Oral Presentation Outline FormatGeneral PurposeSpecific Pur.docx

Oral Presentation Outline Format
General Purpose:
Specific Purpose:
Introduction
I. Attention-getting statement - gain the attention of the
audience by using a quotation, telling a brief story or humorous
anecdote, asking a question, etc.
II. Preview statement - overview of all of your main points.
Body
I. First main point
A. Subpoint
B. Subpoint
II. Second main point
A. Subpoint
B. Subpoint
III. Third main point
A. Subpoint
B. Subpoint
Note: The number of main points and subpoints you use will
vary depending on how much information you have to convey
and how much detail and supporting material you need to use.

Subpoints are comprised of the supporting material you gather
in your research.
You should not have more than five main points in any
presentation.
Conclusion
I. Summary statement - review all of your main points.
II. Concluding statement - prepare a closing statement that ends
your presentation smoothly.
Instructor: Karelia Castañeda
Getting Divisions to Work in the Firm’s Best Interest
22
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CHAPTER
Companies are “principals” who try to align the incentives of
divisions (“agents”) with the goals of the parent company.
Transfer pricing is a big source of conflict between divisions
because they transfer profit from one division to another; they
can also result in too few goods being transferred. Transfer
prices should be set equal to the opportunity cost of the
transferred asset.
A profit center on top of another profit center can result in too
few goods being sold; one common way of addressing this

problem is to change one of the proﬁt centers into a cost center.
This eliminates the incentive conﬂict (about price) between the
divisions.
2
Companies with functional divisions share functional expertise
within a division and can more easily evaluate and reward
division employees. However, change is costly, and senior
management must coordinate the activities of the various
divisions to ensure they work towards a common goal.
Process teams are built around a multi-function task and are
evaluated based on the success of the task.
When divisions are rewarded for reaching a budget threshold,
they have an incentive to lie to make the threshold as low as
possible, to make the threshold easier to reach. In addition, they
will pull sales into the present, and push costs into the future, to
make sure they reach the threshold. A simple linear
compensation scheme eliminate this incentive conflict.
3
continued
Acme
The by-product of producing Acme paper is “black liquor soap”

that is converted into “crude tall oil” used in resin
manufacturing.
The Paper division at Acme sold it’s soap to the Resin company
at a transfer price set by senior management.
But both divisions fought over the transfer price.
The Resin division wanted a low transfer price
The Paper division wanted a high price
The corporate parent company “gave” the Resin department a
very low transfer prices. As a result, the Paper division began
burning the soap as a fuel instead
of selling it to Resin.
The soap’s value as a fuel was below its value as an input into
resin manufacturing.
4
Incentive Conflicts between Divisions
In a multi-divisional company, transactions between divisions
can create incentive conflicts.
In these transactions the company is the principal and divisions
are the agents.
To understand the source of conflicts that arise between
divisions, personify the divisions and consider each to be a
rational actor. Then ask the same three questions
Which division is making the bad decision?
Does the division have enough info. to make a good decision
Does it have the incentive to do so?
Without proper control, these conflicts can deter profitable
transactions from occurring.
5

Incentive conflicts (cont’d)
Again the answers suggest three possible solutions
Change the division that does the decision making,
Change the flow of information, or
Change a division’s evaluation and compensation schemes
Often, parent companies organize so that each division is an
autonomous, and separate profit center.
Definition: A proﬁt center is a division that is evaluated based
on the proﬁt it earns.
The benefit of a profit center is that they are easy to evaluate
(and manage); the cost is that they are concerned only with
their own division profit.
6
Analyzing Black Liquor Soap Problem
Who is making the bad decision? The Paper Division made the
bad decision to burn the soap for fuel instead of transferring it
to the Resins Division.
Did they have enough information to make a good
decision? The Paper Division had enough information to know
that the soap’s value as a fuel was below its value as an input to
resin manufacturing.
And the incentive to do so? The Paper Division was rewarded
for increasing its own profit, not that of the Resin Division.

7
Transfer Pricing
One common belief is that transfer pricing just shifts profits
between divisions & doesn’t affect firm profits.
THIS IS A MYTH.
Sometimes they move assets to lower valued uses, i.e. the
“black liquor soap” incident.
Transfer pricing is always a problem between two profit centers
because they “fight” over the transfer price.
You can get rid of the conflict by turning one division into a
cost center.
A cost center is rewarded for reducing the cost of producing a
specified output. (but remember, cost centers can come with
problems of their own.)
Discussion: Are your transfer prices set equal to the
opportunity cost of the product? If not, why not?
8
Paper Company
A company can transfer paper from its upstream Paper division
to its downstream Cardboard Box division.
The company set a transfer price to guarantee a contribution
margin of 25% to the Paper division.

So, if the Paper MC is $100, the transfer price would be $125
The Box Division considers the transfer price to be its MC, and
then marks up the cost again.
The Box division makes all sales where MR > MC, but now the
MC is overstated (because of the included contribution margin
of the Paper division).
Discussion:
Solution
?
9
Paper company (cont’d)
The analysis makes clear that the conflict arises because two
profit centers are each trying to extract profit from a single
product.
This creates a “double markup” problem.
One way to solve the problem is to make the Paper division a
cost center.

Cost centers are not evaluated based on the proﬁt they earn, and
so don’t care about the transfer price.
Once the Paper division began transferring at MC the Box
division began winning more jobs from its rivals.
10
Organizational options: U-form
Functional (U-form): A functionally organized ﬁrm is one in
which various divisions perform separate tasks, such as
production and sales.
Example of functional organization are Henry Ford’s
automobile assembly line, or Adam Smith’s pin factory.
Advantages:
Workers develop high functional expertise.
Information can be shared easily within a division.
It’s easier to tie pay to performance because performance is
easily measured.
Disadvantages:
Each division must coordinate with each other, a burden that

falls on management; and change is costly.
11
Banking Coordination Problem
Banks have many different divisions, all of which must work
together for the bank to create profits.
The Loan Origination Division (think of them as “mortgage
brokers”) identifies potential borrowers, lends money to them,
and then hands them over to
The Loan Servicing Division, which collects interest on the loan
and makes sure that borrowers repay the loans when they come
due.
For the bank in question, there was an unusually high number of
defaulted loans.
What caused this to occur, and how can it be fixed?
12

Banking problem (cont’d)
Three questions:
Who is making the bad decision? The Loan Origination
Division was making risky loans.
Did the Division have enough information to make a good
decision? The Division could have easily verified the credit
status of the borrowers.
And the incentive to do so? Like many sales organizations,
the Loan Origination Division (“mortgage brokers”) were
evaluated based on the amount of money they were able to lend,
regardless of the credit worthiness of borrowers.
13
Organizational options: M-form
M-Form: An M-form ﬁrm is one whose divisions perform all the

tasks necessary to serve customers of a particular product or in
a particular region.
Advantages:
Divisions can respond more easily to change.
Easier to establish customer relationships because one person
can serve each customer’s needs
Disadvantages:
Individual workers develop less functional expertise.
Example: re-organize a bank into “home” and “business” loans,
where both divisions originate and service loans. This reduces
incentive to make bad loans.
14
Corporate Budgeting: Paying People to Lie
A toy company’s Marketing Division creates sale projections
for each season. The Manufacturing Division uses the forecast
to plan production.
Problem: There was excess inventory at the individual business
units within the toy company.

HINT: each business unit is rewarded with a big bonus if it
meets budget.
This system created incentives for business units to set low
budgets.
The CEO knew this and “stretched” each budget goal, even
though he lacked specific information about business unit.
When the goals were set too high, the inventory was not sold
and accumulated; if too low, stock-outs occurred.
15
Corporate Budgeting: Paying People to Lie (cont’d)
Once budget goals were reached, there was no incentive to
exceed them. (“shirking”)
Also, there are incentives to “game” the system
Accelerate sales or delay costs if just short of target
Delay sales or accelerate costs if target already met to make
next year’s goals easier to reach
Accelerating or delaying sales can be costly, e.g., discounts
offered to customers to delay or accelerate demand.

Discussion: How should it be fixed?
16
Corporate Budgeting: Typical Problem
This threshold compensation scheme creates incentives to lie
17
Corporate Budgeting: solution
Adopting a linear compensation scheme solves problem
18

Title?
Company X, one of the world’s largest suppliers of supplies for
printers, copiers, and fax machines, included two separate
divisions.
Toner Division produced toner, which it sold to the Cartridge
Division and to the external market.
The Cartridge Division integrated the toner into cartridges sold
to original equipment manufacturers and consumers.
Company management allowed the two divisions to negotiate
the transfer price of toner and evaluated each division on its
profitability.
19

Title continued?
After negotiations were unsuccessful, both divisions elected not
to transact.
Toner Division continued to sell to the external market at its
customary price
Cartridge Division elected to buy toner from an external
supplier.
The Cartridge Division ended up buying its toner from the exact
same supplier to whom the Toner Division was selling.
Rather than paying one markup to the Toner Division, the
Cartridge Division ended up paying that markup plus an
additional margin to the external supplier
Price was 38 percent higher cost than originally proposed in
negotiations
External supplier’s shipment arrived at Company X’s docks
with the products still emblazoned with Company X’s logo.
CEO noticed this.
20
$75,000

$4 million$5 million
(Target)
$6 million
Total Compensation
Profit
$95,000
$115,000
Compensation depends on
realizing a minimum profit
level. Managers have an
incentive to game the
system to reach the $4
million level. Also,
managers have no
additional incentives once
profit has reached $6
million.
Compensation
Level
$4 millionRealized
Profit
Performance
$6 million Profit
Compensation no longer

depends on realizing a
minimum profit level. With
no incentive to game the
system (pay is the same
whether profit was targeted
at $4 million or at $6
million), budgets will be
more accurate and useful
in the planning process.
Total Compensation
The Problem of Adverse Selection
19
CHAPTER
Insurance is a wealth-creating transaction that moves risk from

those who don’t want it to those who are willing to bear it for a
fee.
Adverse selection is a problem that arises from information
asymmetry—anticipate it, and, if you can, ﬁgure out how to
consummate the unconsummated wealth-creating transaction
(e.g., between a low-risk customer and an insurance company).
The adverse selection problem disappears if the asymmetry of
information disappears.
2
Screening is an uninformed party’s effort to learn the
information that the more informed party has. Successful
screens have the characteristic that it is unproﬁtable for bad
“types” to mimic the behavior of good types.
Signaling is an informed party’s effort to communicate her
information to the less informed party. Every successful
screen can also be used as a signal.
Online auction and sales sites, like eBay, address the adverse

selection problem with authentication and escrow services,
insurance, and on-line reputations.
3
continued
Zappos
Zappos.com is an online shoe retailer that depends heavily on
customer service – a key differentiator for Zappos.
As part of the hiring process, Zappos recruits are required to
complete a four-week training process.
Zappos discovered that training alone could not imbue
employees with the attitude and personality required to maintain
Zappos’ reputation for customer service.
Specifically, Zappos was having trouble measure such
intangible qualities and devised a system to get the employees
with these qualities to identify themselves.
After one week of training, Zappos offers $2000 to any person
who will quit on the spot.
About 3% of employees take this offer, and the remaining group

generally deliver the quality of service Zappos desires.
4
Introduction: adverse selection
The problem Zappos faces is known as adverse selection.
Zappos want to hire only good employees, but cannot
distinguish the good from the bad.
For Zappos, the employees known whether they are hard
workers with the attitude and personality that Zappos seeks, but
Zappos does not know which employees possess those
attributes.
When one party in a transaction has more or better information
than the other, adverse selection is a problem.
Low-quality employees generally have more incentive to accept
an offer of employment (they might not get another), which
exacerbates the problem of adverse selection.
Employers need to find a way to distinguish the high- from the
low-quality workers. Zappos $2000 offer is one way to “screen”
out the low-quality applicants, and is a solution to the adverse

selection problem.
5
Insurance and risk
The problem of adverse selection is easily illustrated in the
market for insurance.
The demand for insurance comes from consumers who do not
like risk. We model risk as a lottery – a random variable with a
payment attached to each outcome.
A risk-neutral consumer values a lottery at its expected value.
A risk-averse consumer values a lottery at less than its expected
value.
For example, flipping a fair coin. If the coin lands on heads the
payoff is $100; on tails, $0. A risk-adverse consumer would
value the lottery at $40, while a risk-neutral consumer would
value it at %50.
Insurance moves “risk” from the risk adverse consumer (lower
value) to a risk neutral insurance company (high value).
6

Insurance and risk (cont’d)
Insurance is also a wealth creating transaction, except that it
moves a “bad” from someone who doesn’t want it (risk averse
consumer) to someone who willing to accept the risk for a fee
(insurance company).
Numerical example: Rachel owns a bicycle valued at $100.
The bike has a possibility of being stolen, meaning Rachel’s
ownership is like a lottery: lose $100 if it’s stolen, lose $0 if it
isn’t.
If the probability of theft is 20%, then the expected cost of the
lottery is (0.2)($100) = ($20).
If Rachel buys a bike insurance policy that will reimburse her
for the value of the bike if stolen for $25, she eliminates the
risk of owning a bike.
Both insurance company and Rachel are better off with this
policy. The company earns $5 ($25-$20), on average, and
Rachel can stop worrying about bike theft, i.e., she “pays” the
insurance company $25 each year so she doesn’t have to face

the risk of bike theft.
7
Insurance and risk (cont’d)
It’s important to note, the insurance company never actually
earns $5. Either the company loses $75 if the bike is stolen, or
earns $25 if it’s not.
The expected value of offering insurance,
though, is $5
0.2 x ($75) + 0.8 x ($25) = $5
One main function of the financial industry is also the
allocation of risk, moving risk from lower- to higher-valued
uses.
Discussion: Describe precisely how a futures contract transfers
risk from the seller of the contract to the buyer of the contract.
8

The first lesson of adverse selection
To explain on adverse selection, we modify the bike example.
Now suppose that there are two equally sized risk-adverse
consumer groups:
Group 1 with a probability of theft of 0.2
Group 2 with a probability of theft of 0.4
What happens when you try to sell insurance at a price of $35?
HINT: do NOT assume that both groups will purchase at this
price
Because only high-risk consumers would be willing to pay the
higher price, the company would consistently be paying out
policies.
So, anticipate adverse selection and protect yourself against it.
This means anticipate that only the high-risk types will buy, so
price the insurance at $45
9

The first lesson (cont’d)
In 1986, D.C. passed the Prohibition of Discrimination in the
Provision of Insurance Act outlawing HIV testing by health
insurance companies.
As a result many insurance companies left D.C.
The companies were unable to distinguish the low-risk from the
high-risk consumers. If the companies sold only to HIV-positive
consumers they would lose money.
In 1989, the law was repealed, and the adverse selection
problem disappeared. Companies could once again differentiate
between high- and low-risk consumers and offered two
differently priced policies to cover each group.
By eliminating asymmetry of information (insurance companies
could tell who was high-risk and who was low-risk) the problem
of adverse selection was solved.
10

Anticipating adverse selection (cont’d)
In financial markets, adverse selection becomes a problem when
the owners of a company want to sell shares to the public but
know more information about the prospects of the company than
potential investors.
Potential investors should thus anticipate that companies with
poor prospects are most likely to sell to the public.
For example, small initial public offerings (IPOs) of less than
$100 million lose money, on average, whereas large IPOs have
“normal” returns.
The winner’s curse of common-value auctions is also a type of
adverse selection.
11
The second lesson of adverse selection
In the bicycle example, if the insurance company sells policies
at $45, low-risk consumers wont buy (because with their lower
risk, their cost is only $35)
But these consumers would be willing to pay $25, which is still

more than the cost to the company of insuring the bike ($20).
This means the low-risk consumers are not served because it is
difficult to profitably transact with them.
The problem of adverse selection presents many potentially
profitable (unconsummated) wealth-creating transactions.
Using screening or signaling helps overcome the adverse
selection problem so that low-risk individuals can be transacted
with profitably.
12
Screening
One simple solution to adverse selection is to gather enough
information to distinguish high-risk from low-risk consumers.
But this can be difficult and costly to do.
Privacy and anti-discrimination laws frequently prevent
insurance agencies, and other companies, from gathering or
using certain information (race, gender, credit scores).
To solve this problem more indirect methods can be used to
identify individual risk. Screening is an effort by the less-

informed party to induce of consumers to reveal their types.
Information may be gathered indirectly by offering consumers a
menu of choices, and consumers reveal information about their
risks by the choices they make.
13
Screening (cont’d)
Screening is frequently used in the insurance market.
Suppose high-risk individuals prefer full insurance at $45, to
partial insurance (for instance receiving only $50 if your bike is
stolen) at $15.
For a successful screen, it must not be profitable for the high-
risk consumers to mimic the choice of the low-risk consumers.
Using a screening method allows companies to consummate the
unconsummated wealth-creating transactions by eliminating
information asymmetry.
14

Car Buying Screen
In the used car market, adverse selection is known as the
lemons problem.
On a car lot there are bad cars (“lemons”) worth $2000 and
good cars (“cherries”) worth $4000.
Sellers know which cars are cherries and which are lemons.
So, if an uninformed buyer walks onto the lot and offers to buy
a car for $3000, only the lemons owner would sell.
The result is that the buyer overpays by $1000 for a bad car.
But if the buyer offers to pay $4000, both lemons owners and
cherry owners will sell. However, the expected value of the car
in both cases will be $3000, so again the buyer overpays.
Anticipating adverse selection, the buyer will offer only $2,000,
ensuring a lemon, but at least he won’t overpay.
15

Car buying (cont’d)
Owners of good cars are analogous to low-risk insurance
consumers – they are unable to transact.
How can this unconsummated wealth-creating transaction be
consummated? In other words, how can you design a screen for
those who want to buy a cherry, and not a lemon?
One option is to offer to buy a car for $4000 and demand a
money-back guarantee.
If the car is really worth $4000, the cherry owner knows that it
won’t be returned.
But the lemons owner will refuse the offer.
16
Marriage screen
Discussion: Louisiana offers a choice between two marriage
contracts: a covenant contract which makes divorce expensive;
and a regular contract which makes divorce relatively cheap.

How does Louisiana marriage law function as a screen?
HINT: What is adverse selection problem in marriage?
Screening is also useful as implemented by Zappos to identify
high- from low-quality employees.
Zappos made it profitable for low-quality employees to identify
themselves by offering the $2000 payment to quit.
Incentive compensation is another tool companies use to
identify low-quality workers.
17
Incentive compensation as a screen
When hiring sales people there are hard workers, who will sell
100 units per week, and lazy workers, who will sell only 50
units per week.
Asymmetric information means only workers known if they’re
lazy or hard working.
A Straight salary leads to adverse selection.
Because both types of employee will accept an offer of
$800/week, you will attract a mix of lazy and hard workers.

Incentive pay ($10 per sale) solves the problem: hard workers
earn $1000 and lazy workers will reject the offer (they expect to
earn only $500).
Incentive pay imposes risk on the workers – some sales factors
are out of their control.
Another screen with less risk: offer a base salary of $500 plus
$10 per sale for every unit above 50 sales.
18
Signaling
Definition: Signaling describes the efforts of the more informed
party (consumers) to reveal information about themselves to the
less informed party (the insurance company). A successful
signal is one that bad types will not mimic.
Proposition: Any successful screen can also be used as a signal
Low-risk consumers could offer to buy insurance with a big
deductible, good employees could offer to work on commission,
and sellers with good cars could include a warranty with the
purchase.

The crucial element of a successful signal is that it must not be
proﬁtable for the bad-types to mimic the signaling behavior of
the good-types.
19
Signaling (cont’d)
Some of the value of education is in its signaling value.
Students can signal employers that they’re hardworking, quick-
learning, dedicated, etc. by spending the time and money
necessary to pursue an education.
Firms brand and advertise products to signal quality to
consumers.
As a result, most consumers are now willing to pay more for
branded and advertised goods.
Low-quality firms wont find it profitable to advertise because
once consumers use the product and notice the difference, they
will switch brands and the firm will have wasted money on the
advertising.
(Note that some states prohibit advertising, e.g., for financial

advisors, that would serve as a signal of quality.)
20
Adverse Selection on eBay
Sellers have better information than buyers about the quality of
goods being offered for sale.
Anticipating adverse selection leads buyers to offer less, which
makes sellers less willing to sell high quality goods.
Consummated transactions are more likely to leave buyers
disappointed in the quality (“lemons”).
How does eBay try to solve this problem?
By providing:
Escrow services
Fraud insurance
Seller ratings – provided by past buyers
eBay’s ability to address the adverse selection problem has
allowed them to begin selling more expensive items, like cars,
where the problem can result in much bigger losses.
21

Title?
Insurance Company X provides group disability insurance
products to businesses, who in turn offer the product to their
employees
Pricing policies to prevent a loss is difficult since the company
does not know which customers are high-risk (likely to file a
claim)
If policies are priced at the average risk, only high risk
consumer will purchase.
If policies are priced at low risk, both high and low-risk
consumers purchase, leading to expected costs above price.
By using available geographic and industry experience
information as a screening tool, the company was able to
identify groups prone to higher risks and to price those policies
appropriately
Companies in Miami, Florida had (on average) higher long-term
disability claims while companies in Washington, D.C. had
lower long-term disability claims

Short term disability for a teacher might cost 18% more than the
base cost; the same policy for a group of automotive exhaust
repairers would cost 107% more than the base.
22
Pre-Hire “Training”
South Carolina manufacturing firm hiring new employees
Requires 24 unpaid classroom hours over 8 days in 4 week
period
Final step before full-time employment
If candidate is tardy, he/she is sent home and not allowed to
return
Results
Of 30 people, two candidates are sent home
Only ten of the 1,300 workers hired under the program have had
significant attendance issues
Program reduced the rate of bad hires from about eight percent
to less than one percent

23
Getting Employees
to Work in the Firm’s Best Interest
21
CHAPTER
Principals want agents to work for their (the principals’) best
interests, but agents typically have different goals than do

principals. This is called incentive conflict.
Incentive conflict leads to adverse selection (“which agent do I
hire?”) and moral hazard (“how do I motivate agents?”) when
agents have better information than principals.
Three approaches to controlling incentive conflict are
Fixed payment and monitoring (shirking, adverse selection, and
monitoring costs),
incentive pay and no monitoring (must compensate agents for
bearing risk with a risk premium), or
sharing contracts and some monitoring (some shirking and some
risk sharing which leads to lower risk premium).
2
In a well-run organization, decision makers have
the information necessary to make good
decisions and
the incentive to do so.
If you decentralize decision-making authority, you should

strengthen incentive compensation schemes.
If you centralize decision-making authority, you should make
sure to transfer specific knowledge (information) to the decision
makers.
3
continued
To analyze principal–agent conﬂicts, focus on three questions:
Who is making the (bad) decisions?
Does the employee have enough information to
make good decisions?
Does the employee have the incentive (performance evaluation
+ reward system) to make good decisions?
Alternatives for controlling principal–agent conﬂicts center on
one of the following:
Reassigning decision rights (to someone with better incentives
or information)
Transferring information

Changing incentives (performance eval. + reward system)
4
continued
ASI
Auction Service International (ASI) employed art experts to
convince owners of valuable art to use auction services to sell
their artwork.
The auction house profited by charging the art owners a
percentage of the sell price at auction.
This percentage was negotiated by the young art experts.
A problem arose, the negotiated prices (“commissions” to the
auction house), which were supposed to be between 10 and
30%, were consistently low, near 10%.
The CEO of ASI began investigating this phenomenon and
found that the art experts were “trading” low prices for
kickbacks from the art owner.
Discussion: What are two possible solutions for this problem?
5

Principal-Agent Relationships
When studying firm-employee relationships we use principal-
agent models.
Definition: A principal wants an agent to act on her behalf. But
agents often have different goals and preferences than do
principals.
The auction house is a principal;
the art expert is an agent.
Note: for convenience only, we adopt the linguistic convention
of referring to principals as female and agents as male.
6

Incentive Conflict
Because the agent has different incentives than the principal,
the principal must manage the incentive conflict, which comes
down to two problems with which you should by now be
familiar:
Adverse selection: the principal has to decide which
agent to hire
Moral hazard: once hired, the principal must find a way to
motivate the agent.
Both problems are caused by asymmetric information: adverse
selection implies that only the agent knows his “type”; while
moral hazard means that only the agent knows how much effort
he is exerting.
The costs of addressing moral hazard and adverse selection are
known as agency costs, because they are often analyzed by
principal-agent models.
7
Agency Costs

A principal can reduce agency costs if she gathers information
(reduces information asymmetry)
about the agent’s type (adverse selection); or
about the agent’s actions (moral hazard).
Information gathering:
To mitigate adverse selection problems, firms can run
background checks on agents before they are hired.
To mitigate moral hazard problems, firms can monitor an
agent’s behavior while working.
This difference in timing leads to the characterization that
adverse selection is a pre-contractual problem, while moral
hazard is a post-contractual problem.
8
Incentive Pay vs. Risk
Incentive pay can help align the incentives of employees
(agents) with the goals of the organization (principal).
For example, if harder work leads to higher sales, then create
incentives by tying the employee’s reward to sales performance,

e.g., with a sales commission.
But incentive pay also imposes risk on agents.
Commissions mean a portion of an agent’s compensation is
dependent on factors beyond the agent’s control, e.g., weather.
Agents must be compensated for taking on this additional risk.
So, incentive compensation represents a tradeoff:
Does the benefit (harder work by agent) outweigh the cost
(extra compensation for bearing risk)?
9
Controlling incentive conflict
In an ideal organization
Decision-makers have all the information necessary
to make profitable decisions; and
The incentive to do so.
When designing an organization, you should consider how to
structure the following three items.
Decision rights: who should make the decisions?
Information: is the decision-maker provided with enough

information to make a good decision?
Incentives: does the decision-maker have the incentive to do so.
Incentives are created by linking performance evaluation and
reward systems (rewarding good performance).
10
Decision Rights and Information
Who should make decisions?
Decentralize decision making: move decision rights down in the
hierarchy, closer to those with better information; or
Centralize decision making: move decision rights up in the
hierarchy, closer to those with better incentives.
If you decentralize decision-making authority, you should also
strengthen incentive-compensation schemes.
If you centralize decision-making, find a way to transfer
information to those making decisions.
11

Incentives (performance + reward)
Performance evaluation
Informal: using subjective performance evaluation, or
Formal: using objective measures such as sales or accounting
profit, stock price, relative performance metrics.
Rewards: Decide how compensation is tied to performance
evaluation.
Reward good performance and/or penalize
bad performance.
Examples: bonus, increased probability
of promotion, faster promotion.
12
Example: Marketing vs. Sales

Sales and marketing divisions often have incentive conflict
Sales wants to maximize revenue, i.e., make all sales
where MR > 0
Marketing wants to maximize profit, i.e., make all
sales where MR > MC.
In other words, sales prefers a higher level of sales and a lower
price than does marketing.
For example, a large telecommunications equipment company
that serves government agencies that buys telecom equipment.
Sales people want to bid more aggressively to make sure that
they win the contract (they care about maximizing sales)
Marketing wants the sales agents to bid less aggressively, so
that when they do win, the contracts are more profitable (they
care about maximizing profit).
13
Marketing vs. Sales (cont’d)
Two solutions:
Centralize bidding decisions to marketing; and try to transfer

enough information to marketing managers so they know how
aggressively to bid.
Decentralize bidding decisions (keep decision rights with the
sales people) and change incentives – Instead of a 10%
commission on revenue, give sales people a 20% commission on
profit, (revenue neutral if the contribution margin is 50%)
Discussion: How well do threshold compensation schemes
work, e.g., a bonus if you open hit a target sales number.
Discussion: How well do high-powered sales commissions
work, e.g., 5% commission for sales of $1M; 10% commission
on sales of $2M, work?
14
Example: Franchising
Incentive conflict exists between franchisors (McDonalds) and
its franchisees. McDonalds wants big franchise fees and high
quality at franchisees to protect its reputation. Franchisees want
smaller fees and lower quality (cheaper).
McDonalds has both company owned stores and franchisees.

In a company-owned store, both adverse selection and moral
hazard are concerns – managers don’t work as hard as they
would if they owned the restaurant, and a salaried manager
position might attract lazy workers.
Franchisees have bigger incentive to work hard (because they
are the “residual claimants” of profit), but they are also exposed
to more risk. Franchisees have to be compensated (lower
franchise fees) for bearing risk.
15
Franchising (cont.)
Another option is to use a sharing contract: instead of a ﬁxed
franchise fee, the franchisor might demand a percentage of the
revenue or proﬁt of the restaurant.
This arrangement reduces franchisee risk by reducing
the amount the franchisee pays to the franchisor when
the store does poorly.
Sharing contracts may also encourage shirking because
the franchisee no longer keeps every dollar he earns.

Discussion: Why does McDonalds use company-owned stores
along freeways, but franchises in towns?
16
Diagnosing and solving problems
To analyze principal-agent problems, begin with the bad
decision that is causing the problem, and then ask three
questions.
Who is making the (bad) decision?
Did agent have enough information to make a good decision?
Did agent have the incentive to do so, i.e., how is the employee
evaluated and compensated?
Answers to these questions generally suggest alternatives for
reducing agency costs. You can,
Let someone else make the decision, or
Change the information flow, or
Change the incentives.
17

Example: Declining Store Profits
The CEO of a large retail chain of “general stores” that target
low-income customers has noticed that newly opened stores are
not meeting sales projections.
What is the problem here? And how can it be fixed?
Some helpful information about the stores is,
The company uses development agents to find new store
locations and negotiate the leases with property owners – the
company rewards these agents with generous bonuses (stock
options) if they open fifty new stores in a single year.
Agents are supposed to open new stores only if their sales
potential is at least one million dollars per year, but recently
opened stores earn half this much.
What is the problem; and what is the solution?
18

Title?
Whaling ventures in the 1800s were managed by agents, who
would purchase supplies, hire a captain and crew, and plan the
voyage on behalf of the investors.
Agent’s performance difficult for investors to observe or
evaluate
Actions of crew on multi-year voyages even more difficult to
evaluate
Contracts and organizational forms century evolved in response
to these problems
Most whaling enterprises were closely held by a small
number of local investors
Ownership rights were allocated to create powerful
incentives for their managers
Agents usually held substantial ownership shares
in their ventures
19

Title continued?
Attempting to run these ventures via corporation form in the
1830s and 1840s failed
They paid their crews the same ways, used similar vessels, and
employed agents with similar responsibilities
Only main difference was in ownership structures and
hierarchical governance
They were unable to create the incentives requisite for success
in the industry. The managers of these corporations, who did
not hold significant ownership stakes, did not perform as well
as their peers in unincorporated ventures.
20
The Problem
of Moral Hazard

20
CHAPTER
Moral hazard refers to the reduced incentive to exercise care
once you purchase insurance.
Moral hazard occurs in a variety of circumstances: Anticipate it,
and (if you can) ﬁgure out how to consummate the implied
wealth-creating transaction (i.e., ensuring that consumers
continue to take care when the beneﬁts of doing so exceed the
costs).
Moral hazard can look very similar to adverse selection—both
arise from information asymmetry. Adverse selection arises
from hidden information about the type of individual you’re
dealing with; moral hazard arises from hidden actions.
2

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