ECO320Y5 Lecture Notes - Risk Aversion, Salomon Brothers, Deferred Compensation

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Published on 21 Apr 2013
ECO370 Theory Question Compilation
Test 1 Material
Value Maximization Principle for any inefficient allocation, there exists another (total
value maximizing) allocation that all of the parties strictly prefer
Objective of the principal and the agent in establishing a contract is to maximize the
welfare or social surplus of the organization
Only when the value maximization principle is applied then an organization be
assigned and implied by efficiency
Theorem of Coase parties will begin to bargain to max total welfare provided there are no:
High Transaction costs
Wealth effects
When the theorem of coase applies, the outcome, by means of bargaining or by means
of a “law” or “rule” will optimize “joint” surplus of both parties in accordance with
the Value Maximization Principle
If the parties bargain to an efficient agreement displaying no wealth effects, then the
value creating inputs will not depend on bargaining power of initial assets/
The Theorem of coase is important application of the value maximization principle
predicting that two parties will bargain to maximize the total welfare in the contract provided
there are no
High transaction costs
Wealth effects
Salomon Brothers Case:
Major investment bank on Wall Street
Originally had performance pay system involving base salary + annual bonus
Pay system encouraged Salomon’s employees to work extremely hard and take great
risks to increase both their own and their departments’ profits
Discouraged exchange of information between departments
Discouraged cooperation between departments sometimes attempts to steal other
departments’ profits
Negative effect on profits
New plan was a bonus scheme which included a trust for the employee which
deferred bonuses by 5 years. (cannot withdraw for 5 years)
Ensured employees will be concerned with company’s long-run performance
Efficiency Problem when individuals are indifferent about some of the available choices,
then a choice is efficient if there is no other available option that everyone in the relevant
group likes as least as much and at least one person strictly prefers.
If the manager/ EE are able to bargain together effectively + efficiently implement
and enforce decisions, then the outcome of the economic activity will tend to be
From the point of view of economics, the efficiency principle is applied to solve two
economic problems of organization coordination and motivation
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o Coordination when the best action for an individual to take depends on the
action taken by, or the information possessed by, another
Solved through using the firm’s organization structure, which
determines who makes what decisions and how information flows in
the firm
Ex: Scale issues, Specialization, Inter-departmental Costing
o Motivation problem arrises when a:
principal hires an agent to take actions that affect the payoff to the
agents interests differ from those of the principal
there is hidden action or hidden information
Ex: supervision, monitoring, decisions involving outsourcing or
making inputs
Note: X= f(e1) perfect information
X= f(e1) + __ -imperfect information
Risk Premium = [0.5pvar(w)] cost to the agent of the risk that he or she bears in carrying
out an incentive contract
P = coefficient of absolute risk aversion (CARA) and Var(W) = a measure of wage
Amount that an employee would be prepared to pay to switch from receiving a
random income to receiving a certain income
Additional cost that the agent bears
Net Benefit = W-(Ce) Risk Premium agent’s (employee’s) net benefit is the difference
between total compensation and the costs of effort and risk.
Subject to participation constraint NB>0 requiring the benefit to be at a certain level
in order for EE to sign the contract and to entice the agent from alternative activities
NB=0 reflects that the organization are price takers
What the party maximized in order to be part of the organization
Incentive Compatibility Constraint d(NB)/de limitation imposed on a principal
(employer) in a contract to offer an agent (employee) sufficient incentives to minimize the
moral hazard cost he or she could impose on the employer
Employee will select his or her effort level in such a way that the marginal gain from
one additional unit of effort will equal one additional unit of personal cost
The employee –agent “knows” the actual value of e – his or her effort which is
hidden from the principal
First step of the game is for the principal to solve the agent’s problem based on what
the employee knows
Incentive Factor SS =    measures the “intensity” of the agent’s
incentive. Factors affecting the incentive factor include the agent’s constant absolute risk
aversion (CARA) which lowers the level of incentives as it increases. The greater the external
shocks, the weaker (smaller) the incentives.
2nd step of the “game” is for the organization to solve its problem
o The employer knows the assigned value of β
The organization’s problem is to optimize (maximize) the joint surplus of both the
principal and the agent
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Equal Compensation principle
If an EE`s allocation of time between the two activities cannot be monitored, the two
activities must be equal with time or attention spent or the activity with the lower
marginal rate of return will receive zero time and allocation. If B2>B1 it predicts that
the EE will put all the efforts into task 2.
Informative Principle
implies that any measure of performance that reveals information on the effort level
chosen by the agent, should be included in the compensation contract.
Base Wage or Salary (plug in values for e, set = 0) base wage or salary is what the
employee agent needs to enter the contract and relates to the employee- agent’s
participation constraint that which makes entering the contract feasible to the employee
Base Parameter α is derived from the employee’s participation constraint
The participation constraint Net Benefit = 0 determines when the agent would be
willing to participate in the contract
Multitasking vs Team Production Plans
Multitasking an agent is required to perform several tasks on his job (partly
because he has multiple skills)
o With cost independent efforts , agent prefers variety ( multitasking)
o With cost substitutable efforts, the agent cares only about the total effort spent
on the job and generally prefers task specialization
Ex: sales and customer support, teaching and research, data analysis
and data presentation
Team Production concerns a focus on 2 or more different types of inputs of
production provided by two or more agent employees.
o there is specialization but there can be evidence of free riding in teams
o gives workers an incentive to monitor one another via peer pressure
Ex: sports, shared teaching duties
Benefits under each plan
o Social Surplus is higher in a specialized environment and lower when
multitasking prevails
o Specialization might be overshadowed by too much in house competition and
infighting (ie. Salomen Bros.)
o Multi-taskers are paid more
Ratchet Effect There is a tendency for performance standards to increase after a
period of good performance
Soviet quotas
Bricklaying contests in ancient Israel
Call Centres Quotas
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