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University of Toronto Mississauga
Robert Barber

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/ endowments 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 efficient  From the point of view of economics, the efficiency principle is applied to solve two economic problems of organization – coordination and motivation 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 principal  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(e 1 + __ -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 variation  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.  2 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 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 – agent 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 Problem for employee – performance standards increase after a period of good performance • If employees forsee this? • Backward “game” played to lower productivity Ratchet Effect – So one result of the Ratchet effect applies the equal compensation principle. • To optimize effort initially, contracts must be equal across time periods • Otherwise effort intensifies over future periods The McKinsey and Bain case studies • McKinsey – More team oriented projects • Project Turnaround: 4-6 months • Approach more likely to achieve greater coordination among the team members • A higher value in the RPE contract • Cost of compiling and transmitting information among team members would likely be lower - Milgrom & Roberts – 29 • Other points from Milgrom and Roberts – pp. 409 - 410 not mentioned here are acceptable Bain – More individualize projects • Project Turnaround: 18 months • Like centralized decision making, thi
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