ECOS 3003 Tutorial 2 1
Hierarchies, incentives and firm structure ECOS3003
Tutorial 2 answers
1. Is it worthwhile for shareholders to seek to completely eliminate incentive problems with
managers and directors through means such as monitoring? Why or why not?
Possibly not; cost of monitoring versus benefit. If the variables are continuous, monitor up to the point
where the MB = MC (of monitoring); eg the MB from the increased effort by a worker = the increase cost
from monitoring.
It is possible that spot checks and limited monitoring may be optimal.
Another issue is who monitors the monitor? (There is scope for the monitor to collude with the party they
are meant to be observing.)
2. How does concerns about reputation aid in the enforcement of contracts?
Future punishments (cost to reputation) may outweigh short-term gain from cheating.
3. Consider a model with one worker who works for one boss. In each period the worker can
work hard or not work at all. If the worker works hard she will create $8 worth of profit. The boss
can then decide how to share this profit with the worker (that is, how much of the $8 the worker
gets). If the worker does not work she creates $0 profit. There are an infinite number of periods and
both parties discount future payoffs by δ.
There is a social convention that the worker will work hard if in every previous period the boss gave
the worker half of the profit. If this is not the case the worker will not work again in any future
periods. What is the δ required to sustain this social convention as an equilibrium?
Interpret this social convention as an implicit contract.
Boss’s decision, taking worker’s trigger strategy as given.
If worker works hard and the boss shares in every period the payoff to the boss is:
4 + δ.4 + δ2.4 + … = 4 / (1 – δ)
If don’t share (in the first period) the boss gets: 8 + 0 + 0 + … = 8
The boss will share if:
4 / (1 – δ) ≥ 8, or if
δ* ≥ ½
Implicit contract: if share output, worker will continue to do the right thing and work hard (note: sharing
could take different forms like a bonus, time off etc).
4. What is a firm’s organisation architecture?
Assignment of decision rights; method of rewarding individuals; structure of systems to evaluate the
performance of both individuals and business units.
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Note, the fundamental problem is trying to ensure that decision makers have the relevant information to
make good decisions and that these decisions makers have appropriate incentives to use their information
productively.
5. What is the architecture of markets?
The price system and property rights provides the architecture through market transactions decision rights
end up in the possession of those with specific knowledge. Since owners bear the wealth effects, the market
mechanism provides incentives to choose efficient actions.
6. The Australian Competition and Consumer Commission recommends changes in the way
anti-competitive law should analyse mergers. Among other things, the recommendations would likely
make it easier to justify mergers on the grounds that it reduces costs or increases competition. The
idea is that some mergers between competitors result in significant cost savings, enhance competition
and result in lower prices. Would these recommendations affect organization architecture if
adopted? Explain the connection.
If ACCC proposal accepted, regulation will change. The environment will become, arguably more
competitive and interdependent. As a result, companies could have to adjust their strategies, which in turn
could require changes in architecture.
7. Which of the following will affect the design of the optimal architecture?
a. market conditions
b. regulation
c. technology
d. all of the above***
e. none of the above
8. Bob is the owner of a chain of tyre stores in Melbourne and Sydney. Bob makes the pricing a
stock decisions for all of the Sydney outlets, but allows each of the Melbourne store managers to
make their own pricing and stock decisions. How will this change affect the other aspects of the
firm’s architecture?
Bob makes the pricing decision is Sydney market. In Melbourne, managers do prices (use specific
knowledge).
Other aspects of architecture affected;
- how Sydney outlets managed/operated/owned (by Bob?)
- Melbourne franchises? perhaps Melbourne managers have more info on competitors, or the
outlets are located in such a way that there are externalities between stores than in the Sydney market.
The question is really how is this assignment of decision rights going to affect incentive problems and the
need for performance measurement? Given the differences, need different architecture in two cities.
(2) Incentive contracts
• bonuses/sales payments
• franchise businesses (make managers residual claimants
(3) performance evaluation
9. Sharon wants to buy a widget but she knows that 20 per cent of the people she has to deal
with are dishonest. If she deals with a dishonest person she gets $0 benefit. If she deals with an honest
person she gets $20 benefit from the trade. To Sharon, dishonest and honest people look alike ex
ante.
ECOS 3003 Tutorial 2 3
a. Sharon is matched with a potential trader. Will she be willing to trade?
If the potential trading partner is honest he will all make a fair deal and Sharon will receive $20
benefit. The honest person will get $10. A dishonest person however can choose to be honest or
dishonest. If he is honest the benefits to Sharon and to himself are $20 and $10; if he is dishonest
Sharon gets $0 and the trader gets $25 benefit. There are two periods in which trade can occur.
b. In the last period, if trade in the first period was ‘honest’, will Sharon trade again?
c. Now consider the first period. Will an dishonest trader act dishonestly or honestly in the first
period.
d. Now trade can occur potentially an infinite number of times. Sharon adopts a trigger-
strategy if trade is ever dishonest. Both parties have a discount factor of δ. When will the dishonest
trader act honestly?
a. Risk neutral EV = 0.8 (20) = 16 >0
b. Worst case scenario – all dishonest people played honest in first period
EV = $16 > 0; hence trade
c. Trader can choose in first period
Strategy 1: If cheat straight away gets $25 + 0 in the future. Payoff Uc1 = 25 + 0 = 25
Strategy 2: If plays honest in first period, can anticipate trade will occur in period 2
Uh1c2 = 10 +25 = 35
Hence Strategy 2 is better than Strategy 1 – therefore play honest in first period.
The possibility for future trade keeps the trader honest, even if only temporarily. Sharon knows this is the
strategy of a dishonest players, but continues to trade as benefits from trade and probability trader is
dishonest is sufficiently small. (Key – trade will occur in the last period, so don’t get a finitely-repeated
prisoners’ dilemma situation.)
d. Honest payoff:
Vh = 10 + δ.10 + δ2.10 + … = 10 / (1 – δ)
Cheat: Vc = 25
Pay Honest if: 10 / (1 – δ) ≥ 25
δ* ≥ 3/5.
10. What factors encourage a trading party to take another on trust, rather than enforce ‘good’
behaviour with a contract?
1. reputation
2. repeated interaction
3. local/friend
4. punishment for cheating high
5. past interaction positive (learned to trust; increased likelihood future interaction positive)