Incentives and Contracts

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Incentives and Contracts

• Introduction

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Simple Contracts

• Contracts for Cooperation
• Consider total value created
• Use a lump sum payment to compensate for outside
  options
• Main steps
• Work out actions that maximise value created and
  specify them in contract
• Ensure agents are paid enough to want to
  participate

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Real World Contracts

• Value maximisation transfer model is simple and
  can be useful
• This subject what happens when contracting is
  more difficult?
• Hold up problems difficult to write (contingent)
  contracts
• Agency problems difficult to encourage value
  maximising actions

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Fashionably Held-Up

• From John Berendt, Midnight in the Garden of Good
  and Evil, 1994, p.10
• Theres a woman here, a grand dame at the very
  apex of society and one of the richest people in
  the Southeast, let alone Savannah. She owns a
  copper mine. She built a big house in an
  exclusive part of town, a replica of a famous
  Louisiana plantation house with huge white
  columns and curved stairs. You can see it from
  the water. Everybody goes Oooo, look! when they
  pass by it. I adore her. Shes been like a mother
  to me. But shes the cheapest woman who ever
  lived! Some years ago she ordered a pair of iron
  gates for her house. They were designed and built
  especially for her. But when they were delivered
  she pitched a fit, said they were horrible, said
  they were filth. Take them away, she said, I
  never want to see them again! Then she tore up
  the bill, which was for 1,400 -- a fair amount
  of money in those days.
• The foundry took the gates back, but they didnt
  know what to do with them. After all, there
  wasnt much demand for a pair of ornamental gates
  exactly that size. The only thing they could do
  is sell the iron for its scrap value. So they cut
  the price from 1,400 to 190. Naturally, the
  following day the woman sent a man over to the
  foundry with 190, and today those gates are
  hanging on her gateposts where they were
  originally designed to go. Thats pure Savannah,
  And thats what I mean by cheap. You mustnt be
  taken in by the moonlight and magnolias. Theres
  more to Savannah than that. Things can get very
  murky.

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Hold-Up Problems

• Arise when contracts cannot be committed to
• Not completely written
• Subject to renegotiation
• Work is done and bargaining takes place later
• If do not have very strong bargaining power, you
  may not receive sufficient value to cover your
  production costs

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Example Rental Cars

• Renters take actions that reduce asset value. Do
  they pay for full costs? Perhaps specify mileage?
• In one case, a fellow rented a sports car with
  12 miles on it. He took out the high-powered
  engine and installed it in a stock car, to run
  a high-speed 500-mile race. After crossing the
  finish line, he reinstalled the engine in the
  rental car and returned it. The rental company
  could not successfully prosecute because it
  failed to establish the number of miles that had
  been put on the engine. The rental car showed low
  mileage, and the rental fee to the customer/car
  racer was only 24.

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P.J. ORourke

• Theres a lot of debate on this subject
  about what kind of car handles best. Some say a
  front-engined car some say a rear-engined car. I
  say a rented car. Nothing handles better than a
  rented car. You can go faster, turn corners
  sharper, and put the transmission into reverse
  while going forward at a higher rate of speed in
  a rented car than any other kind.

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Solutions

• What should the rental car company do?
• Is there an option preferable relative to
  shutting down?
• What are some analogous situations?

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Agency Problems

• Some examples

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Telegraphs and Gaming

• Paid for messages by the word
• Use of codes and ciphers (1840s US)
• Secret messages (privacy)
• Save on telegraph costs
• Reaction
• 1850s gibberish charged more
• E.g., Festival meant A case of three mammoth
  torpedoes
• 1875 words too long (15 letter limit)
• 1885 limit of 10 letters and had to be genuine
  words but errors gave mistakes in understanding.
• 1890 Used deliberately misspelled words so came
  up with book of 256,740 acceptable words (missed
  many common ones)

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How honest are folks?

• Bagel Business (Feldman)
• Delivered bagels to businesses. Used honour
  system for payment.
• Feldman would badger companies who paid less than
  80
• When are people honest?
• Smaller offices (despite fewer witnesses)
• When the weather is nice
• Not on holidays
• Not high up the corporate ladder

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Agency Problems

• Agent has different goals and interests from the
  principal
• Not possible to specify agents actions in a
  contract
• Simple contracts agent may not undertake value
  maximising actions
• Incentive contracts use outcome-based
  performance pay to motivate agent
• Relational contracts use threat of discontinued
  relationship to motivate agent

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Issues
External Contracting When does outsourcing or
integration create value?
Incentive Contracting What do value maximising
outcome-based contracts look like?
Solving Hold-up Problems
Relational Contracting How to maximise value
without formal contracts
Solving Agency Problems
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Incentive Systems

• What are the limitations to writing incentive
  contracts?
• Costs associated with the bearing of risk
• Hard to separate out the contribution of
  different individuals
• Committing to rewards
• Difficulties in specifying appropriate
  performance measures ...

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Saloman Brothers

• Saloman Brothers is a major investment bank
  headquartered in New York City. Its activities
  include corporate finance and, sales and trading.
  During the mid-1980s, it was the most profitable
  bank on Wall Street.
• Bond trading grew in the 1980s. It was very
  volatile with rates swinging wildly leaving room
  open for speculation and arbitrage. Each small
  decision of traders was critical and could result
  in large profits or losses.
• How to motivate traders? Saloman chose to measure
  and reward individual performance by profits
  alone.

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Short Long-Term Goals

• Compensation involved a base salary and annual
  bonus. Bonuses were determined on the basis of
  profits (almost alone). Some employees received
  millions of dollars in such bonuses. Employees
  worked hard and took risks to raise their
  profits. But this was sometimes at the expense of
  other departments impeding the long term success
  of the firm.
• In response to this, in 1990, a new incentive
  system was adopted. A percentage of individual
  bonuses was paid in the form of stock that could
  not be sold for 5 years. This forced individuals
  to become more farsighted. It encouraged people
  to the firm who intended to stay longer. It also
  encouraged diversification.

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Firms get what they pay for ...

• Heinz division managers received bonuses only if
  earnings increased from the prior year ...
• Result Managers delivered consistent earnings
  growth by manipulating timing of shipments to
  customers and by prepaying for services not yet
  received.

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and again ...

• Dun Bradstreet salespeople earned no
  commission unless the customer bought a larger
  subscription to the firms credit-report services
  than in the previous year ...
• Result In 1989, they faced millions of dollars
  in lawsuits following charges that its
  salespeople deceived customers into buying larger
  subscriptions by fraudulently overstating their
  historical usage.

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to true disaster ...

• Unnamed Computer Firm A manager wants to find
  and fix software bugs more quickly. He offers an
  incentive plan 20 for each bug the Quality
  Assurance people find and 20 for each bug the
  programmers fix. (These are the same programmers
  who create the bugs.)
• Result An underground economy in bugs springs
  up instantly. The plan is rethought after one
  employee nets 1,700 the first week.

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and then Communism

• A worker in a Baltic television manufacturing
  facility told of the rush at the end of each
  month to meet production targets and earn
  bonuses
• We never use a screwdriver in the last week. We
  hammer the screws in. We slam solder on the
  connections, cannibalize parts from other
  televisions if we run out of the right ones, use
  glue or hammers to fix switches that were never
  meant for that model. And all the time the
  management is pressing us to work faster, to make
  the target so we all get out bonuses.
• 2,000 television sets exploded in Moscow each
  year!

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Committing to Rewards

• Part of the problem of providing incentives under
  Communism was the inability of the government to
  commit to not raising production targets in the
  face of performance.
• When incentives were given and targets were met,
  the government would realise such goals were
  possible and raise targets further. Realising
  this, individual managers would reduce their
  effort in order to receive minimal bonuses. This
  raising of targets was termed the ratchet effect.
• Doug Larson Accomplishing the impossible means
  only that the boss will add it to your regular
  duties.
• Ferenghi Rule of Acquisition 285 No good deed
  ever goes unpunished.

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What is this subject about?

• Builds on Managerial Economics
• Broad questions
• How to write contracts that maximise value
  created
• How to structure incentives that align disparate
  interests
• When are mergers/integration warranted to
  maximise value created
• How to manage the incentives and performance of
  employees

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Details

• Mathematical/technical focus
• Case Preparation
• Problem Sets
• Web Page
• Exam

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Worked Example

• Agency Problems and Corporate Jets

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Case 1 Owner-Manager

• Owns 100 of the company
• Jet costs 3m
• Cost savings 1.5m
• Personal utility 1m
• Dont invest as 2.5m lt 3m
• Company value 50m

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Case 2 Part Ownership

• CEO owns 60 of the company
• CEO will buy jet if personal utility exceeds
  total cost of purchase for them
• Bears 60 of 1.5m in net loss or 900,000
• Buy as 900,000 lt1m
• Company value falls to 48.5m
• Total value falls to 49.5m

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Mitigating Agency Costs

• Monitoring
• Suppose its costs 200,000 to monitor decision
• Company value still falls to 49.8m
• Bonding
• Can this be done?
• Is it worthwhile?

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Who bears agency costs?

• If CEO owns company and wants to sell 40 stake,
  what happens?
• Market anticipates agency problem and monitoring
  costs. So values the company at 49.8m.
• CEO only receives 19.92m in cash and her own
  stock is valued at 29.88m summing to 49.8m.
  CEO bears all of the cost.

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Acquisition Decision

• CEO owns 5 of firm
• Acquire small firm for 20m but only worth 10m
• CEO only bears 5 of this cost 500,000
• Chooses to acquire as personal utility exceeds
  this amount.
• Total value falls by 9m
• Hard to monitor this type of decision

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Class Discussion

• Relative Merits of Incentive Plans

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Bonuses versus Penalties

• Job Offers
• Scheme A pays 10,000 per month, plus a bonus of
  1 for every unit sold
• Scheme B pays 15,000 per month, with a
  5,000-unit quota, penalising the worker 1 for
  every unit under quota
• Which offer is more likely to attract workers?
• Which offer is likely to generate the greatest
  incentives?