SOLUTION: Managerial Economics Prince Mohammad bin Fahd University case study

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Incentive Conflicts and Contracts
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Table of Contents
1.
Introduction …………………………………………………………………………………………………………….. 3
2.
Incentive Conflicts within Firms ………………………………………………………………………………… 4
2.1 Owner-Manager Conflicts ………………………………………………………………………………………. 4
2.1.1 Sources of conflict between managers and owners ………………………………………………. 4
3.
Other Conflicts ………………………………………………………………………………………………………… 6
4.
The Role of Contracts ………………………………………………………………………………………………. 7
5.
Costless contracting, costly contracting, and asymmetric information ……………………………. 7
6.
Postcontractual Information Problems ………………………………………………………………………… 7
6.1 Agency Problems …………………………………………………………………………………………………… 7
7.
Pre-contractual Information Problems ………………………………………………………………………… 8
7.1 Bargaining Failures and Adverse Selection ……………………………………………………………….. 8
8.
Implicit and Reputational Contracts …………………………………………………………………………… 9
9.
Conclusion ……………………………………………………………………………………………………………… 9
References ……………………………………………………………………………………………………………………. 10
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Incentive Conflicts and Contracts
1. Introduction
According to Brickley et al. (1997), firms are characterized based on administrative
decision-making. While firms use managers to allocate resources, markets utilize price. Therefore,
the main discussion revolves around the comparative efficiency of markets and firms. The firm is
treated as if it has a single central manager who works towards maximizing the value of the
enterprise. The characterization is broadly used in economics and it helps in understanding the
firm’s pricing and production decisions. Nevertheless, the actual process of decision-making is
exceptionally complicated and varies from the simple concept of characterization (Brickley et al.,
1997). A firm usually has several decision-makers with the board of directors (BOD) assuming
the role of policy decision-making in large companies. The CEO named by the BOD retains
specific significant decision rights and delegates several operating decisions including financing,
production and pricing to managers at the lower level. According to Brickley (1999), even the
lowest-paid worker in the firm often has some authority to make certain decisions. The main goal
of the majority of these decision-makers is not based on the maximization of the firm’s value.
Transfer prices or internal pricing systems are used by firms to apportion internal resources.
Organizational issues faced by the firm can be analyzed when there is adequate information
regarding various pertinent concepts. Economists have developed numerous helpful definitions.
The firm is considered a focal point for a set of contracts. Therefore, it implies that the firm is a
creation of the lawful system and granted an individual’s legal standing. Brickley et al. (1997)
avow that a firm can enter into a legal contract, be sued, and sue. The expression focal point is
used to show that the firm is usually a party to every contract that comprises the firm. Some of the
examples of these contracts include franchise agreements, leases, bonds, customer warranties,
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supplier contracts, and employee contracts. This paper focuses on incentive conflicts within firms,
the role of contracts, and problems associated with post-contractual and pre-contractual
information.
2. Incentive Conflicts within Firms
Individuals are characterized by economic theory as innovative maximizers of their utility.
Therefore, the groups of people who enter into a contract with the firm are not expected to have
automatically-aligned goals (Brickley et al., 1997). While the firm owners are interested in
maximizing the current value of the residual profits, some employees within the firm may not
necessarily share similar goals. Consequently, there are significant incentive conflicts that are
experienced within a firm. Nonetheless, contracts can be used to control and reduce such conflicts.
2.1 Owner-Manager Conflicts
Owners of firms often delegate managerial roles to qualified managers. For example, the
shareholders in large companies own the residual profits, and they, in turn, delegate considerable
decision authority to the top management organs within the company (Brickley, 1999). The
conflict between owners and managers can make the firm go out of business, cause waste and lead
to loss of productivity.
2.1.1 Sources of conflict between managers and owners
2.1.1.1 Choice of Effort
The firm’s value increases when managers put extra effort into their work. However, the extra
effort decreases the managers’ utility because they expend the effort.
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2.1.1.2 Perquisite Taking
Company owners are always interested in paying sufficient bonuses and salaries to retain
and attract experienced and professional managers. Nevertheless, the firm owners often try to
avoid overpaying the employed managers. On the contrary, managers often desire higher salaries
and perquisites including luxurious automobiles, lavish office furniture, and exclusive club
membership (Brickley et al., 1997). Conflict can arise when lower employees are underpaid while
managers are overpaid thus resulting in loss of productivity.
2.1.1.3 Differential risk exposure
Managers normally invest considerable levels of personnel wealth and human capital
within the firm. Such enormous investments can cause managers to appear extremely risk-averse
from the owner’s point of view. Consequently, Brickley et al. (1997) assert that managers might
be compelled to relinquish projects that they foresee would be beneficial just because they do not
want to bear the menace that the project might not succeed and result in reduced rewards.
Managers will always concentrate on their personal interests whether the shareholders or owners
are making a loss.
2.1.1.4 Differential horizons
Claims by the managers within the firm are generally restricted by their terms with the
firm. As a result, managers have restricted incentives to take into account the cash flows that go
beyond their term in office (Brickley, 1999). In contrast, firm owners are concerned about the
potential value of cash flow streams because it determines the selling price for the claims. Although
the owners focus on their profits, managers simply want to carry out their duties and make
sufficient money to become rich.
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2.1.1.5 Over-investment
Managers often want to empire-build even if the firm has exhausted the existing investment
projects which are deemed profitable. Furthermore, managers are usually hesitant to dismiss
friends and coworkers in non-profitable departments (Brickley et al., 1997). Although managers
who send away their colleagues put up with personal costs, shareholders are the highest
beneficiaries. In such circumstances, managers would rather bear the loss of profits by the
shareholders or owners than let their colleagues lose their jobs.
3. Other Conflicts
Contracting parties within the firm are likely to face similar kinds of incentive conflicts. For
instance, high-ranking managers are concerned about perquisite and effort hence triggering issues
with lower-level personnel. The shareholders and creditors to a firm might raise issues and cause
disputes over optimal investment policies, financing, and dividend of the firm. At the same time,
firms can have incentives to fail to pay warranties with the clients (Brickley et al., 1997). Managers
usually fall out with labor unions. Conflicts between suppliers and buyers arise when the firmowners insist on acquiring inputs of high quality at low prices while the owners of the supplying
firms offer economical inputs at high prices. The major concern of supplying firms is the demand
for price concessions by the purchasing firms. On the other hand, the purchasing firms are
concerned that suppliers will either increase prices or reduce costs by shirking on the quality of
the product.
Incentive conflicts further arise under circumstances of joint ownership. For instance, the
actions of every partner in a large accounting firm affect the firm’s profits that are eventually
shared by the partners. Brickley et al. (1997) affirm that such arrangements often drive partners to
free-ride on other partners’ efforts. Every partner expects that the other partners will work
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industriously to ensure the firm’s profitability. Nevertheless, every partner has a particular
incentive to shirk within the firm. Issues of free-rider are common in several group activities and
require a proper check-up to prevent an imminent reduction in the teams’ output.
4. The Role of Contracts
Contracts help in controlling incentive conflicts from undermining joint responsibilities within
the firm. Company owners might be dissuaded from delegating functional authority to managers
for the fear that the managers will utilize company resources for their selfish interests (Brickley et
al., 1997). Explicit and implicit contracts define the organizational architecture of the firm based
on reward systems, performance evaluation, and decision rights. The architecture offers a
significant set of incentives and constraints that assists in resolving incentive issues.
5. Costless contracting, costly contracting, and asymmetric information
Contracts are considered ideal when they align interests or minimize conflicts arising from
incentives at low or no cost. Practically, contracts are never costless to negotiate because they
require legal fees to write, administer and implement. Brickley et al. (1997) reiterate that costly
information is the main factor that limits the contract’s ability to resolve incentive conflicts. Parties
to any legal contract have asymmetric information on the levels of performance. Information
problems arising from contracting are grouped into two major categories. Informational
asymmetries arise before the negotiation of the contract and during contract enforcement.
6. Post contractual Information Problems
6.1 Agency Problems
An agency relationship is defined as an agreement whereby a single party known as the
principal engages the other party referred to as an agent to carry out some activities on behalf of
the principal. Brickley et al. (1997) assert that several agency relationships occur within the firm.
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For instance, the boards of directors are appointed by the shareholders to act as agents to supervise
the firm’s management. Most of the operating authority is delegated by the boards to senior
executives who in turn assign duties to lower-level staff members. The incentives of agents and
principals are never aligned automatically thus creating agency problems. After entering into a
contract, agents have incentives to take appropriate action that improves their well-being at the
principal’s expense. For example, managers of a firm might choose operating and investment
policies that minimize profits but enhance their potential well-being.
Asymmetric information complicates the resolution of agency problems and normally excludes
costless resolution of the contracting issues. The agent can take part in activities including
prerequisite taking and shirking without the principals detecting because they cannot examine the
agent’s actions costlessly. Nevertheless, Brickley et al. (1997) noted that such behaviors can be
limited by the principal by using the contract to initiate adequate incentives for the agent and by
sustaining monitoring costs. Moreover, agents might end up incurring bonding costs as an
assurance that they will not take specific actions or guarantee that the principal will benefit from
the compensation. Asymmetric information further complicates the resolution of agency problems
since the agent incurs bonding costs while the principal sustains monitoring costs.
7. Precontractual Information Problems
7.1 Bargaining Failures and Adverse Selection
Asymmetric information can bar parties from arriving at a particular agreement even when a
constructed contract would be equally beneficial theoretically. Strikes by employees lead to lower
sales and productivity that ultimately generate fewer profits to be apportioned between the
company and labor. Parties in a contract may overreach during negotiations thus stopping
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negotiations. Brickley et al. (1997) define adverse selection as the use of private information in a
way that is detrimental to the business partner.
8. Implicit and Reputational Contracts
Implicit contracts entail understandings and promises that cannot be formalized under legal
documentation. Brickley et al. (1997) emphasize that they largely depend on individual’s private
incentives for the terms to be honored. For example, promises of salary increment and promotions
for a job are well-executed and informal agreements that suppliers will not compromise the quality
of the products. Contract compliance is motivated by reputational concerns. The market can
enforce significant costs on individuals and institutions for deceitful behavior. Therefore, market
forces can offer influential private incentives to ensure integrity actions. Reputational concerns are
considered effective in enhancing contract compliance under three conditions (Brickley, 1999).
The gains derived from cheating are must be insignificant and the probability of discovering
cheating has to be higher. Finally, the anticipated sanctions enforced when cheating is detected
must also be higher. Reputational concerns are less efficient in stimulating contract compliance
when the conditions are not fulfilled.
9. Conclusion
Firms are treated as individual decision-makers who aim at maximizing profits. A firm is
regarded as a focal point for various contracts. Individuals are major incentive conflicts among the
parties that enter into a contract with the firm. The conflicts include free-rider, buyer-supplier, and
owner-manager conflicts. Implicit and explicit contracts play a significant role within a firm by
specifying the organizational architecture based on the reward system, performance evaluation,
and reward systems. The organizational architecture establishes a set of incentives and contracts
that can minimize the costs associated with incentive conflicts. Incentive problems cannot be
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completely resolved by contracts because they are costly to implement, administer and negotiate.
Agency relationships often result in incentive problems because the agents seldom act in the best
interests of the principals. Differences in interests can be limited when the principal structure the
contract to identify proper incentives for the agent.
Besides, the principal might incur monitoring costs to restrict the agent’s dysfunctional
activities. The agents might also incur bonding costs as an assurance that they will not act against
the interest of the principal. Generally, complete resolution of incentive conflicts attracts residual
loss. Asymmetries in pre-contractual information can lead to breakdowns in adverse selection and
bargaining. Costs associated with adverse selection reduce the profits from trade and eventually
cause market failures. Problems of pre-contractual information can be resolved through warranties,
credible communication, the clever design of contracts, and information collection. Most of the
contracts initiated by firms are implicit contracts other than the legal documentation. The implicit
contracts are not easily enforceable in a court of law and extensively rely on individual’s private
incentives for implementation. Implicit contracts can be honored through reputational concerns
that offer a variety of incentives.
References
Brickley, J. A. (1999). Incentive conflicts and contractual restraints: Evidence from
franchising. The Journal of Law and Economics, 42(2), 745-774.
Brickley, J. A., Smith, C. W., Zimmerman, J. L., Zhang, Z., & Wang, C. (1997). Managerial
economics and organizational architecture. Chicago: Irwin.

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