Bo Com Lectures

333 views

Published on

Published in: Business, Economy & Finance
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
333
On SlideShare
0
From Embeds
0
Number of Embeds
13
Actions
Shares
0
Downloads
3
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Bo Com Lectures

  1. 1. BoCOM Lectures Jiahua Che University Of Illinois March 4, 6, & 11
  2. 2. Introduction <ul><li>Purposes of the Lecture Series </li></ul><ul><ul><li>Concepts and ways of thinking, no panacea </li></ul></ul><ul><li>Cautioning </li></ul><ul><ul><li>Role switching between banker and manager </li></ul></ul><ul><ul><li>We will at times abstract to highlight key economic intuitions behind certain concepts </li></ul></ul><ul><ul><li>Some discussions might therefore appear artificial </li></ul></ul>
  3. 3. Private Mechanism v.s Government Intervention <ul><li>Boundaries of Government Intervention </li></ul><ul><ul><li>One of the defining characteristics of the Chinese economy is the heavy government involvement </li></ul></ul><ul><ul><li>There are pros and cons for government involvement in economic activities </li></ul></ul><ul><ul><li>The issue is what defines the boundaries of government intervention </li></ul></ul>
  4. 4. Private Mechanism v.s Government Intervention <ul><li>Outside government intervention </li></ul><ul><ul><li>Economic activities are carried out through private mechanism </li></ul></ul><ul><ul><li>Private mechanism includes market mechanism </li></ul></ul>Government intervention Market mechanism Private mechanism
  5. 5. Private Mechanism v.s Government Intervention <ul><li>Examples of Non-Market Private Mechanism </li></ul><ul><ul><li>Market mechanism here refers to traditional arms-length, anonymous, nucleus, transactions </li></ul></ul><ul><ul><li>Non-market private mechanism includes </li></ul></ul><ul><ul><ul><li>Explicit or implicit contractual arrangement </li></ul></ul></ul><ul><ul><ul><li>Informal agreement supported by trust and reputation </li></ul></ul></ul><ul><ul><ul><li>Non-government-owned firms and organizations </li></ul></ul></ul>
  6. 6. Private Mechanism v.s Government Intervention <ul><li>Externality and Government Intervention </li></ul><ul><ul><li>Externality is often thought of as a case for government intervention </li></ul></ul><ul><ul><li>Externality: </li></ul></ul><ul><ul><ul><li>Refers to a situation where one person’s action affects another person’s well-being, which is not accounted for by market mechanism </li></ul></ul></ul><ul><ul><li>Example of externality: </li></ul></ul><ul><ul><ul><li>麻将 and neighbors </li></ul></ul></ul>
  7. 7. Private Mechanism v.s Government Intervention <ul><li>The 麻将 - neighbors problem </li></ul><ul><ul><li>You love tranquility but your neighbor loves 麻将 </li></ul></ul><ul><ul><li>Assumptions: </li></ul></ul><ul><ul><ul><li>Without 麻将 , your well being is valuated at X, your neighbor’s well being is at Y </li></ul></ul></ul><ul><ul><ul><li>With 麻将 , your well being is valuated at X - a, your neighbor’s well being is at Y + b </li></ul></ul></ul><ul><ul><ul><li>Loss in well being can be compensated through monetary transfer </li></ul></ul></ul><ul><ul><ul><li>Both you and your neighbor have lots of money </li></ul></ul></ul>
  8. 8. Private Mechanism v.s Government Intervention <ul><li>The 麻将 - neighbors problem and Coase Theorem </li></ul><ul><ul><li>The efficient outcome </li></ul></ul><ul><ul><ul><li>Efficient outcome: no alternative universally preferred by people involved </li></ul></ul></ul><ul><ul><ul><li>麻将 to be played if X + Y < X – a + Y + b, or b > a </li></ul></ul></ul><ul><ul><ul><li>麻将 to be played otherwise </li></ul></ul></ul><ul><ul><li>Private contractual arrangement </li></ul></ul><ul><ul><ul><li>I: your neighbor may pay you “to be allowed” to play 麻将 , or </li></ul></ul></ul><ul><ul><ul><li>II: you may pay your neighbor for his “right” to play 麻将 </li></ul></ul></ul><ul><ul><ul><li>Key: there is a right associated with playing 麻将 , this right may be initially allocated to you (I) or to your neighbor (II) </li></ul></ul></ul>
  9. 9. Private Mechanism v.s Government Intervention <ul><li>The 麻将 - neighbors problem and Coase Theorem </li></ul><ul><ul><li>Regardless how the right is initially allocated, the outcome emerging from the private contractual arrangement is the efficient outcome </li></ul></ul><ul><ul><li>(1) The outcome through private contracting is efficient </li></ul></ul><ul><ul><li>(2) Allocation of property rights does not affect the outcome </li></ul></ul>
  10. 10. Private Mechanism v.s Government Intervention <ul><li>The 麻将 - neighbors problem and Coase Theorem </li></ul><ul><ul><li>Suppose b > a </li></ul></ul><ul><ul><li>If you initially have the right, your well-being (after compensation) may be X + b – a; if your neighbor initially has the right, your well-being (after compensation) may be X </li></ul></ul><ul><ul><li>(3) Allocation of property rights affects redistribution: separation between efficiency and redistribution </li></ul></ul>
  11. 11. Discussion <ul><li>Application </li></ul><ul><ul><li>The case of bank operation </li></ul></ul><ul><ul><ul><li>Bank lending unprofitable yet helpful to local economy </li></ul></ul></ul><ul><li>Keys to Coase Theorem </li></ul><ul><ul><li>Well-defined and enforced property rights </li></ul></ul><ul><ul><li>Flexibility in prices: emphasizing the role of prices </li></ul></ul>
  12. 12. Introducing Contractual Difficulties <ul><li>Barriers to Perfect Contracting and Limits to Coase Theorem </li></ul><ul><ul><li>Information asymmetry </li></ul></ul><ul><ul><ul><li>Parties to a transaction may be differently informed concerning the nature of the transaction, either ex ante or ex post </li></ul></ul></ul><ul><ul><li>Contractual renegotiation </li></ul></ul><ul><ul><ul><li>Parties to a transaction may choose to rearrange terms of the transaction in the middle of the transaction </li></ul></ul></ul><ul><ul><li>Contract reneging </li></ul></ul><ul><ul><ul><li>One party may choose not to abide the terms of the transaction </li></ul></ul></ul><ul><ul><li>Contractual incompleteness </li></ul></ul><ul><ul><ul><li>Some scenarios relevant to a transactions may not be covered in the initial contracting </li></ul></ul></ul>
  13. 13. The limits to the Role of Prices <ul><li>The Case of Credit Rationing and Information Asymmetry </li></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>Two borrowers, each want to borrow $1 from you to invest on a project </li></ul></ul></ul><ul><ul><ul><li>You, a banker, has only $1 </li></ul></ul></ul><ul><ul><ul><li>Should you lend the $1 to whoever bids the highest interest rate? </li></ul></ul></ul><ul><ul><li>Assumption: </li></ul></ul><ul><ul><ul><li>One borrower has a risky project, which has return Q with prob q and 0 with prob 1 - q </li></ul></ul></ul><ul><ul><ul><li>The other has a safe project, which has return R with prob 1 </li></ul></ul></ul>
  14. 14. The limits to the Role of Prices <ul><li>The Case of Credit Rationing and Information Asymmetry </li></ul><ul><ul><li>Assumption: </li></ul></ul><ul><ul><ul><li>R(1 + q)/2 > qQ and Q > R </li></ul></ul></ul><ul><ul><ul><li>Limited liability </li></ul></ul></ul><ul><ul><ul><li>You don’t know who has a risky project and who has a safe one </li></ul></ul></ul><ul><ul><li>Analysis </li></ul></ul><ul><ul><ul><li>Let r be the interest rate </li></ul></ul></ul><ul><ul><ul><li>If lend to the highest bidder, you will be lending to the risky project. Your expected profit = q(1 + r)  qQ </li></ul></ul></ul><ul><ul><ul><li>If limit the interest rate so that 1 + r = R, you ration $1 between the two borrowers. Your expected profit = R(1/2 + q/2) > qQ </li></ul></ul></ul>
  15. 15. Contracting with Information Asymmetry <ul><li>Pre-contractual Opportunism </li></ul><ul><ul><li>Example: parties may have different private information regarding the nature of the transaction (adverse selection) </li></ul></ul><ul><li>Post-contractual opportunism </li></ul><ul><ul><li>Example: parties take unobservable actions post-contracting </li></ul></ul><ul><ul><li>(moral hazard) </li></ul></ul>
  16. 16. Pre-Contractual Opportunism & Contractual Responses <ul><li>Adverse Selection </li></ul><ul><ul><li>The origin of the term and the idea of the concept </li></ul></ul><ul><ul><ul><li>The case of insurance </li></ul></ul></ul><ul><ul><li>The consequence of adverse selection: </li></ul></ul><ul><ul><ul><li>When adverse selection becomes very serious, the markets may collapse. </li></ul></ul></ul>
  17. 17. Pre-Contractual Opportunism & Contractual Responses <ul><li>Adverse Selection </li></ul><ul><ul><li>Example: The “lemon” problem </li></ul></ul><ul><ul><ul><li>In used car market, qualities of used cars vary, known to owners but to buyers </li></ul></ul></ul><ul><ul><ul><li>Buyers pay price according to average used car quality on market </li></ul></ul></ul><ul><ul><ul><li>Owners of better quality used car to withdraw from the market, leaving only used cars of below-average quality to stay </li></ul></ul></ul><ul><ul><ul><li>Average quality is lowered and buyers pay lower price …. </li></ul></ul></ul><ul><ul><li>A similar example: </li></ul></ul><ul><ul><ul><li>Bad coins drive out good coins </li></ul></ul></ul>
  18. 18. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses to Adverse Selection </li></ul><ul><ul><li>Rationing </li></ul></ul><ul><ul><li>Limiting parties’ choices </li></ul></ul><ul><ul><ul><li>bundled insurance and universal coverage </li></ul></ul></ul><ul><ul><ul><li>Automobile leasing </li></ul></ul></ul><ul><ul><li>Preventing information gathering in the first place </li></ul></ul>
  19. 19. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses to Adverse Selection </li></ul><ul><ul><li>Signaling </li></ul></ul><ul><ul><ul><li>Privately informed parties adopt behaviors that reveal their information; in response, the contract incorporates these behaviors that otherwise may be irrelevant to the transaction </li></ul></ul></ul><ul><ul><li>Screening </li></ul></ul><ul><ul><ul><li>Uninformed parties take actions to separate different types of privately informed parties along certain dimension; typically done through a menu of alternatives, each intended for a particular type of these informed parties </li></ul></ul></ul>
  20. 20. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses to Adverse Selection </li></ul><ul><ul><li>How does signaling work: the advertisement example </li></ul></ul><ul><ul><ul><li>Image a situation where products are of high or low quality </li></ul></ul></ul><ul><ul><ul><li>Suppose that in such an environment, manufactures of high quality products make costly advertisement; while manufactures of low quality products do not advertise </li></ul></ul></ul><ul><ul><ul><li>In this case, buyers will buy advertised products at a premium, since advertisement reveals products being of high quality </li></ul></ul></ul>
  21. 21. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>The advertisement example continued </li></ul></ul><ul><ul><ul><li>Why manufactures of high quality products will advertise but those of low quality products do not? </li></ul></ul></ul><ul><ul><ul><li>The key is to realize: if product quality can be differentiated, high quality product manufactures can make more profits than low quality product manufactures. </li></ul></ul></ul><ul><ul><ul><li>In this case, the former can spend cost in advertisement and still remain profitable, while the latter cannot do so. </li></ul></ul></ul><ul><ul><ul><li>The interesting thing is when the former makes costly advertisement but the latter does not, product quality is differentiated! </li></ul></ul></ul>
  22. 22. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>Illustration of the advertisement example </li></ul></ul><ul><ul><ul><li>Suppose without quality differentiation, profits for each manufacture = $100. Suppose with quality differentiation, profits for high quality product manufacture = $200, profit for low quality product manufacture = $50. Finally, assume cost of advertisement = $80 </li></ul></ul></ul><ul><ul><ul><li>In this environment, low quality product manufacture will never advertise, since 100 - 80 < 50 </li></ul></ul></ul><ul><ul><ul><li>Given that low quality product manufacture will not advertise, high quality product manufacture will indeed advertise, since 200 - 80 > 100 </li></ul></ul></ul>
  23. 23. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>How does signaling work: the essence </li></ul></ul><ul><ul><ul><li>The key to signaling is that a contract incorporates observed behaviors from which private information is revealed </li></ul></ul></ul><ul><ul><ul><li>Such information revelation must be credible, which in this case means that the behaviors must be adopted by some (e.g. high quality product manufacture) but not by others (e.g., low quality product manufacture) </li></ul></ul></ul><ul><ul><ul><li>This condition is known as the self-selection condition </li></ul></ul></ul><ul><ul><ul><li>In other words, signaling works only when the self-selection condition is met </li></ul></ul></ul>
  24. 24. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>Illustration of the self-selection condition </li></ul></ul><ul><ul><ul><li>Consider the advertisement example. Now suppose without quality differentiation, profits for each manufacture = X. Suppose with quality differentiation, profits for high quality product manufacture = H, profit for low quality product manufacture = L. Finally, assume cost of advertisement = Y </li></ul></ul></ul><ul><ul><ul><li>Advertisement is a credible signal if and only if the high quality product manufacture is willing to advertise while the low quality product manufacture is not </li></ul></ul></ul><ul><ul><ul><li>This means: H - Y > X (high quality product manufacture prefers ad to not) and L > X - Y (low quality product manufacture prefers not to ad to ad). </li></ul></ul></ul>
  25. 25. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>Self-selection and screening </li></ul></ul><ul><ul><ul><li>Credible information revelation is also the key to screening </li></ul></ul></ul><ul><ul><ul><li>Therefore screening works only the self-selection condition holds, in which case each party finds it optimal to choose the alternative intended for it </li></ul></ul></ul>
  26. 26. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>Example of self-selection in screening </li></ul></ul><ul><ul><ul><li>The firm, which is a monopoly, offers two contracts </li></ul></ul></ul><ul><ul><ul><li>In contract 1, buyers pay for </li></ul></ul></ul><ul><ul><ul><li>product at price p 1 but has to </li></ul></ul></ul><ul><ul><ul><li>buy at least q 1 amount </li></ul></ul></ul><ul><ul><ul><li>In contract 2, buyers pay for </li></ul></ul></ul><ul><ul><ul><li>product at price p 2 </li></ul></ul></ul>Contract 1: (p 1 , q 1 ) Contract 2: (p 2 ) p 2 p 1 q 1 q 2
  27. 27. Pre-Contractual Opportunism & Contractual Responses <ul><li>Contractual Responses and Self Selection </li></ul><ul><ul><li>Example of self-selection in screening continued </li></ul></ul><ul><ul><ul><li>Contract 1 is intended for buyers represented by green demand curve </li></ul></ul></ul><ul><ul><ul><li>Contract 2 is intended for buyers represented by rend demand curve </li></ul></ul></ul><ul><ul><ul><li>Clearly, green buyers will not choose contract 2 and red buyers will not choose contract 1 </li></ul></ul></ul><ul><ul><ul><li>Therefore, even though the firm does not know buyers’ types, it induces buyers to self-select and hence to reveal their own types by offering these two different contracts </li></ul></ul></ul><ul><ul><ul><li>And as the diagram shows, the firm maximizes its profits with respect to each of these two kinds of buyers </li></ul></ul></ul>
  28. 28. Pre-Contractual Opportunism & Contractual Responses <ul><li>Efficiency in Contractual Responses </li></ul><ul><ul><li>Despite contractual responses, efficient outcome may not achieved </li></ul></ul><ul><ul><ul><li>Example: costly advertisement </li></ul></ul></ul><ul><ul><li>In some cases, contractual “responses” could make things even worse </li></ul></ul>
  29. 29. Pre-Contractual Opportunism & Contractual Responses <ul><li>Efficiency in Contractual Responses to Adverse Selection </li></ul><ul><ul><li>Example: screening and statistical discrimination </li></ul></ul><ul><ul><ul><li>Employers believe women below age 35 unproductive and choose not to hire </li></ul></ul></ul><ul><ul><ul><li>Because women below age 35 are not hired, such belief, even if false, is not contested: efficiency loss #1 </li></ul></ul></ul><ul><ul><ul><li>Expecting not to be employed after age 35, women do not make long-term investment in skills: efficiency loss #2 </li></ul></ul></ul><ul><ul><ul><li>Self-fulfilling: but the employee’s belief is confirmed </li></ul></ul></ul><ul><ul><ul><li>Government intervention called for? </li></ul></ul></ul>
  30. 30. Post-Contractual Opportunism & Contractual Responses <ul><li>Moral Hazard </li></ul><ul><ul><li>The idea of the concept </li></ul></ul><ul><ul><ul><li>Actions involved in a transaction are not always observable and therefore Efficient actions not freely observable and as a result parties taking them may choose to purse their own interests at others’ expense </li></ul></ul></ul><ul><ul><li>Two forms of moral hazard: </li></ul></ul><ul><ul><ul><li>Parties may take inefficient actions </li></ul></ul></ul><ul><ul><ul><li>Parties may provide false information (leading others to take inefficient actions) </li></ul></ul></ul><ul><ul><li>The origin of the term and its moral/efficiency connotation </li></ul></ul>
  31. 31. Post-Contractual Opportunism & Contractual Responses <ul><li>Moral Hazard </li></ul><ul><ul><li>Incidence of moral hazard </li></ul></ul><ul><ul><ul><li>Moral hazard is often thought as taking place in principal-agent relation, where the agent acts on behalf of the principal and is supposed to advance the principal’s interest </li></ul></ul></ul><ul><ul><li>Examples of moral hazard </li></ul></ul><ul><ul><ul><li>Employee shirking </li></ul></ul></ul><ul><ul><ul><li>Managerial misbehavior </li></ul></ul></ul><ul><ul><ul><li>Fraud </li></ul></ul></ul><ul><ul><ul><li>Corruption </li></ul></ul></ul>
  32. 32. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Monitoring </li></ul><ul><ul><li>Role of monitoring </li></ul></ul><ul><ul><ul><li>Preventing bad behaviors from happening </li></ul></ul></ul><ul><ul><ul><li>Providing basis for reward and punishment </li></ul></ul></ul><ul><ul><li>Ways of monitoring </li></ul></ul><ul><ul><ul><li>ex ante, interim, and ex post monitoring </li></ul></ul></ul><ul><ul><ul><li>Monitoring through competing sources: the case of department stores </li></ul></ul></ul><ul><ul><ul><li>Peer monitoring with group incentives </li></ul></ul></ul><ul><ul><ul><li>Monitoring by markets </li></ul></ul></ul>
  33. 33. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>How incentive contracts provide incentives </li></ul></ul><ul><ul><ul><li>Contracts link reward to agents to their performance while agents’ actions determine their performance </li></ul></ul></ul><ul><ul><ul><li>e.g. workers’ pay linked to output/profits which in turn determined by workers’ efforts </li></ul></ul></ul><ul><ul><li>Keys to provide incentives </li></ul></ul><ul><ul><ul><li>In providing incentives, it is not the level of reward that matters </li></ul></ul></ul><ul><ul><ul><li>It is the margin (i.e., the difference between reward when performance is good and reward when performance is bad) that matters </li></ul></ul></ul>
  34. 34. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Risk-bearing and incentive provision </li></ul></ul><ul><ul><ul><li>Existence of moral hazard has to do with the stochastic relation between performance and behaviors, because without stochastic elements, perfect contracting will be feasible </li></ul></ul></ul><ul><ul><ul><li>Therefore risk bearing by the agents is inevitable in incentive provision </li></ul></ul></ul><ul><ul><ul><li>Optimal incentive contract must balance incentives and risks </li></ul></ul></ul>
  35. 35. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Incentive contract and “statistical inference” </li></ul></ul><ul><ul><ul><li>Incentive contract works in a way as if the principal uses performance measures to estimate the actions chosen by the agent and assign payments accordingly </li></ul></ul></ul>
  36. 36. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>Setting: </li></ul></ul></ul><ul><ul><ul><li>probability(good performance | high effort ) = p </li></ul></ul></ul><ul><ul><ul><li>probability(good performance | high effort ) = q </li></ul></ul></ul><ul><ul><ul><li>“Statistical inference” </li></ul></ul></ul><ul><ul><ul><li>If high performance is observed, one can estimate the likelihood that the agent “has exerted high effort”, i.e., </li></ul></ul></ul><ul><ul><ul><li>probability(high effort | good performance) </li></ul></ul></ul><ul><ul><ul><li>similarly, if bad performance is observed, one can estimate the likelihood that the agent “has exerted low effort”, i.e., </li></ul></ul></ul><ul><ul><ul><li>probability(low effort | bad performance) </li></ul></ul></ul>
  37. 37. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>Clearly, how large a margin the principal will provide depends on these two probabilities: </li></ul></ul></ul><ul><ul><ul><li>probability(high effort | good performance) and probability(high effort | bad performance) </li></ul></ul></ul><ul><ul><ul><li>For example, if the two probabilities are close, then the principal cannot tell whether good performance indicates high effort, in which case the margin in the agent’s pay should be minimal </li></ul></ul></ul><ul><ul><ul><li>The difference in these two probabilities represent the precision in the “statistical inference” </li></ul></ul></ul>
  38. 38. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Incentive contract and “statistical inference” </li></ul></ul><ul><ul><ul><li>The margin should increase as the precision improves </li></ul></ul></ul><ul><ul><li>AS IF “statistical inference” </li></ul></ul><ul><ul><ul><li>When a contract is actually given out, the agent chooses a particular action under the contract </li></ul></ul></ul><ul><ul><ul><li>In particular, if the contract is effective, the agent will in fact choose high effort </li></ul></ul></ul><ul><ul><ul><li>There is no statistical inference in actuality, except the contract is designed as if one makes “statistical inference” </li></ul></ul></ul>
  39. 39. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>The incentive-intensity principle: </li></ul></ul><ul><ul><ul><li>How large the margin should be depends on (1) agent’s risk tolerance, (2) precision in which agent’s action is estimated, (3) the importance of the right action relative to the wrong actions, and (4) the agent’s responsiveness to the margin </li></ul></ul></ul><ul><ul><li>The informativeness principle: </li></ul></ul><ul><ul><ul><li>Include performance measures that allows reduce the error with which the action is estimated; exclude performance measures that increase the error with which the action is estimated </li></ul></ul></ul>
  40. 40. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Monitoring intensity principle: </li></ul></ul><ul><ul><ul><li>Devote more resources to monitoring the performance measure if it is desirable to have more intensive incentives </li></ul></ul></ul><ul><ul><li>Balanced incentive principle: </li></ul></ul><ul><ul><ul><li>Suppose the agent allocates resources among different activities on behalf of the principal and that such allocation cannot be monitored by the principal. Then equally intensive incentives should be offered towards these activities, or resources will not be allocated to the activity that is provided with weaker incentives </li></ul></ul></ul>
  41. 41. Post-Contractual Opportunism & Contractual Responses <ul><li>Controlling Moral Hazard: Incentive Contracts </li></ul><ul><ul><li>Application 1: </li></ul></ul><ul><ul><ul><li>Comparative performance evaluation – tournament </li></ul></ul></ul><ul><ul><li>Application 2: </li></ul></ul><ul><ul><ul><li>Job design and asset ownership </li></ul></ul></ul><ul><ul><li>Discussion: </li></ul></ul><ul><ul><ul><li>Structuring incentives in the Chinese economy </li></ul></ul></ul>
  42. 42. Post-Contractual Opportunism & Contractual Responses <ul><li>Rents, Efficiency, and Market Competition </li></ul><ul><ul><li>Limits to monetary incentives </li></ul></ul><ul><ul><ul><li>Incentive contracts sometimes require agents to pay cash penalty for misbehaviors, but agents may be cash constrained to afford such penalty </li></ul></ul></ul><ul><ul><ul><li>A more subtle constraint comes when the performance evaluation is subjective </li></ul></ul></ul>
  43. 43. Post-Contractual Opportunism & Contractual Responses <ul><li>Rents, Efficiency, and Market Competition </li></ul><ul><ul><li>Efficiency wage contract </li></ul></ul><ul><ul><ul><li>An efficiency wage contract pays an agent (a worker in this case) a (fixed) wage higher than market-clearing wage if his performance is satisfactory, and the contract is terminated otherwise </li></ul></ul></ul><ul><ul><li>Efficiency wage contract, termination and unemployment </li></ul></ul><ul><ul><ul><li>Suppose all firms face the same incentive problems. All will offer efficiency wage contracts. Then efficiency wage rate is also the market wage rate </li></ul></ul></ul><ul><ul><ul><li>In order for termination to be “penalizing”, workers must risk being unemployed after termination </li></ul></ul></ul><ul><ul><ul><li>In other words, labor market must not clear --- labor supply must be greater than labor demand on the labor market </li></ul></ul></ul>
  44. 44. Post-Contractual Opportunism & Contractual Responses <ul><li>Rents, Efficiency, and Market Competition </li></ul>Labor Labor supply Labor demand Efficiency wage Market clearing wage Wage Unemployment
  45. 45. Post-Contractual Opportunism & Contractual Responses <ul><li>Rents, Efficiency, and Market Competition </li></ul><ul><ul><li>Rents and efficiency </li></ul></ul><ul><ul><ul><li>Because workers are paid wage higher than market-clearing rate, they earn rents </li></ul></ul></ul><ul><ul><ul><li>It is the rents they earn provide incentives for workers to perform </li></ul></ul></ul>
  46. 46. Post-Contractual Opportunism & Contractual Responses <ul><li>Moral Hazard in Team </li></ul><ul><ul><li>Group performance measure and free riding </li></ul></ul><ul><ul><ul><li>A different kind of difficulty in motivation arises when a group of people work as a team </li></ul></ul></ul><ul><ul><ul><li>In such a teamwork environment, individual members tend to free ride on other members’ efforts </li></ul></ul></ul><ul><ul><ul><li>Furthermore, in teamwork, it is often the case that the team performance is available but the performance measures of individual members are not available </li></ul></ul></ul>
  47. 47. Post-Contractual Opportunism & Contractual Responses <ul><li>Moral Hazard in Team </li></ul><ul><ul><li>Incentive contract in teamwork </li></ul></ul><ul><ul><ul><li>Incentive contracts in this case serve the purpose of combating free riding </li></ul></ul></ul><ul><ul><ul><li>Economic analysis finds that if an incentive contract always distributes returns among team members, such a contract will not overcome free-riding </li></ul></ul></ul><ul><ul><ul><li>In a team work setting, an incentive contract works only if the entire group will lose a part of the return when performance is </li></ul></ul></ul>
  48. 48. Dynamic Incentives <ul><li>Opportunism and Rents in Future </li></ul><ul><ul><li>Another way to control moral hazard is to offer rents in the future, while the offering will depend on the current performance </li></ul></ul><ul><ul><li>Example 1: Bonding </li></ul></ul><ul><ul><ul><li>Agents may post a bond that they will lose if their performance falls short of target </li></ul></ul></ul><ul><ul><ul><li>Application in financial contracting: collateral and seniority in financial claims </li></ul></ul></ul><ul><ul><li>Example 2: Seniority Pay and Career Concern </li></ul></ul><ul><ul><ul><li>Agents expect pay higher than market rate later in the employment tenure </li></ul></ul></ul>
  49. 49. Dynamic Incentives <ul><li>Opportunism and Rents in Future </li></ul><ul><ul><li>Example 2: Seniority Pay and Career Concern </li></ul></ul>Seniority-based pay Market wage Employment tenure
  50. 50. Dynamic Incentives <ul><li>Impediments in Formal Contract Enforcement </li></ul><ul><ul><li>Formal contract enforcement requires contracting to be explicit </li></ul></ul><ul><ul><ul><li>But detailed contracting may be too costly; </li></ul></ul></ul><ul><ul><ul><li>Some specifics involved in transactions may not be enforced; </li></ul></ul></ul><ul><ul><ul><li>Sometimes subjective measurement has to be included in a contract; </li></ul></ul></ul><ul><ul><ul><li>And other times transactions rely on mutual understanding </li></ul></ul></ul><ul><ul><li>Formal contract enforcement depends on well-functioning legal system </li></ul></ul><ul><ul><ul><li>Legal system generically applied, not tailored to specific situations </li></ul></ul></ul><ul><ul><ul><li>Legal system is often cumbersome, time consuming, and expensive </li></ul></ul></ul><ul><ul><ul><li>Legal rules tend to be based on historical precedents, and hence unresponsive to changes </li></ul></ul></ul><ul><ul><ul><li>Judges and juries may lack expertise and may be corrupted </li></ul></ul></ul>
  51. 51. Dynamic Incentives <ul><li>Reputation and Informal Contract Enforcement </li></ul><ul><ul><li>The working environment of reputation mechanism </li></ul></ul><ul><ul><ul><li>Parties’ behaviors cannot be legally contracted, but parties themselves have enough information to evaluate each other’s past behavior </li></ul></ul></ul><ul><ul><ul><li>Repeated transactions between the parties </li></ul></ul></ul>
  52. 52. Dynamic Incentives <ul><li>Reputation and Informal Contract Enforcement </li></ul><ul><ul><li>The functioning of reputation mechanism </li></ul></ul><ul><ul><ul><li>Parties’ behaviors in a particular transaction can be classified into three categories: </li></ul></ul></ul><ul><ul><ul><li>cooperation (trust is offered and honored), </li></ul></ul></ul><ul><ul><ul><li>unilateral defection (trust is offered but not honored), and </li></ul></ul></ul><ul><ul><ul><li>non-cooperation (trust not offered) </li></ul></ul></ul><ul><ul><ul><li>There are gains (rents) in cooperation (as compared to no-cooperation) </li></ul></ul></ul><ul><ul><ul><li>but also temptation to cheat </li></ul></ul></ul><ul><ul><ul><li>and loss to be cheated </li></ul></ul></ul>
  53. 53. Dynamic Incentives <ul><li>Reputation and Informal Contract Enforcement </li></ul><ul><ul><li>The functioning of reputation mechanism: Illustration </li></ul></ul><ul><ul><ul><li>Trust offeror </li></ul></ul></ul><ul><ul><li>Decision maker Trust Do not trust </li></ul></ul><ul><ul><li>Honor trust W, V 0, 0 </li></ul></ul><ul><ul><li>Do not honor </li></ul></ul>Unilateral defection -L, V + G 0, 0 Non-cooperation
  54. 54. Dynamic Incentives <ul><li>Reputation and Informal Contract Enforcement </li></ul><ul><ul><li>The functioning of reputation mechanism: </li></ul></ul><ul><ul><ul><li>Without repetition of interactions between the offeror and the decision maker, the decision maker will not honor trust, and the offeror will not offer trust </li></ul></ul></ul><ul><ul><ul><li>With repeated interactions, decision maker may find it in his own interest to honor the trust, provided that the long term gain from cooperation exceeds the short term benefit from defection </li></ul></ul></ul><ul><ul><ul><li>The long term gain from cooperation exceeds the short term benefit from defection, because cooperation leads to long term dealings while one-time cheating destroys trust and cuts short of these dealings </li></ul></ul></ul>
  55. 55. Dynamic Incentives <ul><li>Reputation and Informal Contract Enforcement </li></ul><ul><ul><li>Keys to reputation mechanism </li></ul></ul><ul><ul><ul><li>There must be (frequent) future interactions; and </li></ul></ul></ul><ul><ul><ul><li>There must be rents for future cooperation! </li></ul></ul></ul><ul><ul><li>“ End game” problem and some possible solutions </li></ul></ul><ul><ul><ul><li>Golden handshake and retirement funds </li></ul></ul></ul><ul><ul><ul><li>Sale of business </li></ul></ul></ul>
  56. 56. Dynamic Incentives <ul><li>Reputation and Informal Contract Enforcement </li></ul><ul><ul><li>Reputation and third party sanctions </li></ul></ul><ul><ul><ul><li>In many situations, a decision maker may have repeated dealings with a group of trust offerors, but has only non-repeated or infrequent dealings with each one within the group </li></ul></ul></ul><ul><ul><ul><li>Example: business and customers </li></ul></ul></ul><ul><ul><li>Role of formal institutions in third party sanctions </li></ul></ul><ul><ul><ul><li>Information dissemination: credit rating and better business bureau </li></ul></ul></ul><ul><ul><ul><li>Ambiguity, rules, principles and “informal laws” </li></ul></ul></ul><ul><ul><ul><li>Rumors and verification </li></ul></ul></ul>
  57. 57. Dynamic Incentives <ul><li>Promotions </li></ul><ul><ul><li>Dual functions of promotions: </li></ul></ul><ul><ul><ul><li>Allocating talents </li></ul></ul></ul><ul><ul><ul><li>Providing incentives and rewards </li></ul></ul></ul><ul><ul><li>Why promotions instead of hiring from outside </li></ul></ul><ul><ul><ul><li>Better talents are needed at higher level positions because these positions usually have a larger impact </li></ul></ul></ul><ul><ul><ul><li>Internal promotions better collect information about talents than hiring from outside </li></ul></ul></ul><ul><ul><ul><li>For this very reason, promotions may also reveal information to outside labor market competition </li></ul></ul></ul>
  58. 58. Dynamic Incentives <ul><li>Promotions </li></ul><ul><ul><li>The potential conflict in the dual functions of promotions </li></ul></ul><ul><ul><ul><li>A person performing well on the current position may not suit for the job at a higher level position </li></ul></ul></ul><ul><ul><ul><li>Possible solution: multiple promotion tracks </li></ul></ul></ul>
  59. 59. Dynamic Incentives <ul><li>Promotions </li></ul><ul><ul><li>Disadvantages of promotion incentives, as compared to monetary incentives </li></ul></ul><ul><ul><ul><li>Promotions are discrete </li></ul></ul></ul><ul><ul><ul><li>Promotions rely on positions availability, thus infrequent </li></ul></ul></ul><ul><ul><ul><li>Promotions create competition </li></ul></ul></ul><ul><ul><ul><li>“Peter Principle” </li></ul></ul></ul>
  60. 60. Dynamic Incentives <ul><li>Promotions </li></ul><ul><ul><li>Advantages for promotions incentives, as compared to monetary incentives </li></ul></ul><ul><ul><ul><li>Only relative performance measures available </li></ul></ul></ul><ul><ul><ul><li>Common elements to the uncertainty in performance </li></ul></ul></ul><ul><ul><ul><li>Helps managers to commit to implementing incentives </li></ul></ul></ul>
  61. 61. Dynamic Incentives <ul><li>Promotions </li></ul><ul><ul><li>Job-attached pay and promotions </li></ul></ul><ul><ul><ul><li>Promotions are often linked to the fact that pay is attached to different jobs </li></ul></ul></ul><ul><ul><ul><li>A number of reasons for pay to be job-attached </li></ul></ul></ul><ul><ul><ul><li>(1) performance is often difficult to be measured </li></ul></ul></ul><ul><ul><ul><li>(2) performance is often evaluated in a decentralized fashion, job-attached pay restricts managerial discretion </li></ul></ul></ul><ul><ul><ul><li>(3) together with promotion possibility, job-attached pay creates incentives </li></ul></ul></ul>
  62. 62. Dynamic Incentives <ul><li>Promotions </li></ul><ul><ul><li>Promotions, efficiency wage and internal labor markets </li></ul></ul><ul><ul><ul><li>In reality, firms typically implement internal labor-market systems that share the following features: </li></ul></ul></ul><ul><ul><ul><li>Workers are mostly hired in at the entry level </li></ul></ul></ul><ul><ul><ul><li>Pay is attached to jobs with various performance standards </li></ul></ul></ul><ul><ul><ul><li>Good performers on the job are promoted in rank as well as in pay </li></ul></ul></ul><ul><ul><ul><li>Bad performers on the job are dismissed </li></ul></ul></ul><ul><ul><ul><li>Such systems serve two purposes: (1) to sort various talents into different positions, and (2) to provide incentives through long-term career concerns along with rents from efficiency wage </li></ul></ul></ul>

×