Contracting, Governance

and Organizational Form

Chapter # 15

• Coordination and control are problems for all business

organizations. The larger the organization, the larger the
problem.
• Contracts help insure performance, but most contracts are
incomplete, and thus can be thwarted through moral
hazard.
• Goods are allocated in free markets by using prices.
• However, there are alternative allocative mechanisms that
are adopted, such as vertical mergers to avoid using prices.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part. Slide 1
 Role of Business Contracting in
Cooperative Games
• The amount of advertising and service can be
viewed as a game.
• The outcome can be sub-optimal; that is, it is not
value maximizing. The cooperative solution
sometime yields better payoffs.
• To get to a value-maximizing solution, the
manufacturer may have to consider side payments
or credible commitments to the retailer.

Slide 2
 Figure 15.1
Vertical Requirements Contracting
• A manufacturer (M) can update its product or not update it.
• The retail ( R) can continue selling efforts or not
• If M updates, R discontinues efforts, but best is for M to advertise anyway and get
$280,000 and R $120,000. If R continues efforts, R will end up with just $100,00.
• How do we get the maximum payoff for both $480,000, Retail Manufacturer
when each has an incentive to shirk? Advertise $180,000 $300,000
Continue Not
selling efforts M1 Advertise $100,000 $350,000

Advertise $120,000 $280,000**

R1
Update M2 Not
Discontinue Advertise $ 40,000 $120,000
selling efforts
M Continue
selling efforts Not
M3 Advertise $60,000 $380,000
Not
Update R2
Discontinue Not
selling efforts
M4 Advertise $130,000 $150,000
Slide 3
 Contracts
• Contracts between players are binding, they
specify actions by both parties.
» A contract is a third party enforceable agreement to
facilitate deferred exchange.
• Contracts must assign penalties for not living up
to the agreement. These payments are part of a
several step sequential game.
» If the retailer decides to discontinue a service for a
product the manufacturer produces, then the contract
can provide economic sanctions that make this
decision unattractive.
Slide 4
 Vertical Requirements Contract
• A vertical requirements contract is one in which the firms in
successive stages of production agree to payments and/or
penalties for taking an action.
• Contracts must assign penalties for not living up to the
agreement. These payments are part of a several step
sequential game.
» If the manufacturer spends a large amount to advertise the product,
the distributor promises to promote the product as well.
• Expectation damages are remedies for breach of contract designed
to elicit efficient precaution and efficient reliance on promises. These
are payments for non-performance of a contract.

Slide 5
 Frustration of Purpose
Doctrine
• Suppose you enter into an agreement to sell a
truck that uses 100% ethanol.
• But suppose the government changes rules making
ethanol use prohibited.
• The Uniform Commercial Code (UCC) provided
the frustration of purpose doctrine to excuse the
truck manufacturer from delivering something it is
prohibited in doing. This would likely give the
truck manufacturer a way to avoid ‘expectation
damages’ if sued by the truck retailer.

Slide 6
 A Spectrum of Contract
Environments
• Spot Market Transaction – one time only exchange of
standardized goods
» Tends to be between anonymous buyers and sellers, and
information tends to be efficient
» The purchase of a dozen ears of corn at a roadside stand or the sale
of electricity at a spot rate off the grid, are examples of spot
markets.
• Vertical Requirements Contracts – promise of future
performance for immediate consideration
» Tends to be between contract partners that know each other, but
there are problems with ambiguity
• Relational Contract – between repeat business parties
» Tends to be self-enforcing because we can see if the other partner
lives up to his or her word.
Slide 7
 Incomplete Information and
Incomplete Contracting
• Incomplete Information -- uncertain knowledge of
payoffs, choices, or types of opponents a market player
faces.
• Insurance works when we can pool a group of possible
events (like injuries at work) to reduce the risk of loss to
any one party.
• But some risks are catastrophic, like a nuclear accident.
It is difficult to assess the likelihood or the damage;
hence, insurance in this case is often unavailable.
• Contracts can specify duties under several states of the
world, but sometimes the outcomes are too numerous or
unknowable for years. This creates incomplete
contracts.
Slide 8
 Types
• Full contingent claims contract -- specifies all
possible future events.
• Incomplete contingent claims contract -- not
all possible future events are specified.
• Due to incomplete contracts, some people may
take advantage of spirit of the contract.
 Accident insurance may permit people to succumb
to a moral hazard by acting recklessly.

Slide 9
 Corporate Governance and the
Problem of Moral Hazard
• Doing business in markets involves the cost of contracts.
• When only incomplete contracts are possible, it is often the
best to integrate the operations within a firm.
• The moral hazard problem occurs when parties change their
behavior due to contracts. This is especially true when the
people’s effort is hard to observe.
• In a borrower-lender contract, a reliable borrower, once given
money in a loan, may elect to invest in highly risky projects.
» To try to avoid this moral hazard, the bank may insist on
costly monitoring or governance actions, forcing the
borrower to submit frequent financial data.

Slide 10
 Implementaion of Mechanisms of
Corporate Governance
Table 15.2
• Internal monitoring by an independent board of
director subcommittee
• Internal/external monitoring by large creditors
• Internal/external monitoring by owners of large
blocks of stock
• Auditing and variance analysis
• Internal benchmarking
• Corporate culture of ethical duties
• High employee morale supportive of whistle blowers

Slide 11
 The Principal-Agent Model
• The agents (managers) may wish to maximize leisure and
minimize risk, whereas the principal (shareholders) may wish
hard work and high risk-return investments.
• Example: an employee knows that working hard helps the
whole firm, and helps himself only a little. Why not let the
other workers be grinds and take it easy (be a free rider)?
• Principal-Agent problems may lead to:
• Risk Avoidance in Managers
• Managers have Short Time Horizons
• Sales Maximization
• High Levels of Social Amenities at the Work Site
• Satisficing or Sufficing Behavior

Slide 12
 Alternative Managerial Labor Contracts

• A consultant is hired for 50 Figure 15.3

hours at Wa.
• Alternatively, a manager is paid
a profit-sharing payment, ray $
AB, which is 40% of the profits
» The first 22 hours, the
consultant is
overcompensated area AJD E
» The last 28 hours, consultant A
is under-compensated area
DCF I O D C
Wa J SL
» If Area O = Area U, the U
consultant is indifferent
between fixed wage Wa and F DL
the 40% profit sharing deal
• If profit sharing were reduced, to 10 22 50 B
IB, then the consultant would
prefer the fixed wage rate.
Slide 13
Work Effort, Creative Ingenuity, and
the Moral Hazard Problem
• Profit sharing, in the previous example, has a problem.
• After the first 22 hours, if the work is not observed, the
consultant can earn Wa, at other work.
• It is disloyal, but rational not to work has hard as
possible for this employer.
• The shirking consultant works for two employers.
• With this outcome expected by the employer, the
employer decides against offering a profit-sharing
contract, and if possible, attempts to monitor the
consultant by a piece rate.

Slide 14
 Principal-Agent Problem
in Managerial Labor Markets
• Stockholders (principals) hire managers (agents) with
different incentives.
• Alternative labor contracts
 Pay based on profits
 Paying a bonus on top of a salary when goals are exceeded
 Have manager own stock
• Benchmarking involves a comparison of similar
firms, plants, or divisions

Slide 15
 Signaling and Sorting
of Managerial Talent
 Applicants to positions know more about
themselves than they reveal, which is the problem
of asymmetric information.
Asymmetric Information -- unequal or
dissimilar knowledge among market participants.
 For example, is the applicant highly risk averse or
a risk taker?
 If I ask you if you are highly risk averse, you will likely
tell me what I want to hear.
 How can we sort between risk-takers and risk
averse candidates?
Slide 16
 Screening and Sorting of Managerial Talent
with Optimal Incentives Contracts
• A Linear Incentive Contract is a combination of salary
and (plus or minus!) a profit sharing rate.
• A Pooling Equilibrium is an offer that dominates all other
offers will not help distinguish among applicants.
• A Separating equilibrium is an offers that distinguishes
between behaviors
• For example, a risk averse person would tend to
select an offer which primarily paid a base salary
• Whereas the risk-loving individual would tend to
select an offer with more profit sharing.
Slide 17
 Sorting Managers with Incentives
Indifference
curve for the
• Contract A has lower
Base Rate risk averse person profit sharing rate and
Salary Indifference lower base rate than
curve for the Contract B
risk lover
• Both a risk averse
B
person and a risk
lover picks B over A
A • This results in a
pooling equilibrium.

Profit sharing points of

Profit Sharing Rate Equal profit to the firm
Figure 15.4
in  percentages
Slide 18
 Sorting Managers with Incentives
Indifference • Consider the choice
curve for the
Base Rate risk averse person between job offer A and C
Salary Indifference
• The Risk Lover picks
curve for the Contract C
risk lover
• The Risk Averse worker
picks Contract A
• Now we have
A C separating
equilibrium.

Profit sharing points of

Profit Sharing Rate Equal profit to the firm
in  percentages
Slide 19
 Choosing the Efficient
Organizational Form
• A reliant asset is at least partially non-redeployable
durable asset.
» Specialized equipment or specialized knowledge cannot be
transferred to other uses.
• In markets with reliant assets, one party could “hold-up”
the other party. The choice of organization will require
explicit contracts.
• The likely outcome is franchise contracts or vertical
integration.
• Relational contracts are promissory agreements of
coordinated performance.
» Pepsi selling Starbucks cold frappuccino in Pepsi vending
machines is a relational contract or alliance agreement.

Slide 20
 The Efficient Organizational Form Depends
on Asset Characteristics
Table 15.3
Fully Redeployable Nonredeployable
Durable Assets Reliant Assets

Not Dependent on Spot market Long-term supply

Unique recontracting contracts +
Complements risk management
One-Way Relational contracts Vertical integration
Dependent Assets (alliances)

Bilateral Dependent Relational contracts Fixed profit-sharing

Assets (joint ventures) contracts

Slide 21
 Prospect Theory
Motivates Full-Line Forcing
• Utility theory in economics is based on the LEVEL of wealth or
income received. More money leads to higher satisfaction or utility.
• But Prospect theory is based on the choice relative to a base point.
The difference (or the prospect) is categorized as either a gain or loss.
• Buy now, pay later has both a gain (the goods now) and the loss (the
pay later)
• A car purchase as a “loss” of the money paid, but as a “gain” if you
think you got a good deal. It can also help explain why manufacturers
offer many versions (a full-line) of automobiles to get the customer to
trade up to a pricier version.

Slide 22
 Prospect Theory & Full-Line Forcing:
Figure 15.5
Town & Country
+140 Minivan
+100
Caravan SXT

$17,000
$22,000 $27,000 $32,000
Losses Full Option Gains
VALUE Caravan
-160
FUNCTION Caravan Base SE

• With full options, the Caravan costs $22,000. Other prospects viewed from this.
• Moving down to the Base SE version is viewed as a loss of 160 in value, but at
$5,000 less. The customer decides to move up to the Full Option Caravan.
• Moving up to a Caravan SXT costs another $5,000, with a gain of 100 value.
Slide 23
 Uses for Prospect Theory
• It helps explains why companies
pay dividends • It explains packaging that
» Gains should be separated with four says, 35% more for free.
checks a year. » Separate gains and
• It explains why companies
losses, to create a Silver
announce all the bad news at one
time
Lining.
» Bundle all the negative prospects • It explains why we wrap
together
Christmas and Birthday
• It explains the purchases of $750
stereos in Cars gifts separately
» Bundled together » Separate gains.

Slide 24
 Vertical Integration
• Vertical integration is a way to avoid
transaction costs, such as moral hazard, which
are found in arm's length (or market) dealing.
• The two stages of production are merged.
The producer ships goods to the next stage of
the same firm.
• If each stage of production has some
monopoly power, the profits can be higher by
merging the two stages.

Slide 25
 Vertical Integration in the Hosiery Market
• Suppose yarn is used in
Ph’ making hosiery (socks) in
Ph fixed proportions.
• Let the marginal cost of
yarn (MCy) and hosiery
Py’ +MCh manufacture (MCh) be
MCy +MCh constant.
• The profit maximizing
MCh hosiery price is Ph
• But if the price of yarn is
Py’ Higher yarn prices raised to Py’ the price ends
Py MCy up too high at Ph’ with
MRh DEMAND smaller total profits for the
hosiery + yarn industries.
Quantity (lbs.)
Figure 15.6 Slide 26
Mergers with
Upstream Competitors

• Hence, if one firm manufactured yarn and another

firm manufacturer hosiery, the merged firm could
be run optimally and be more profitable than
separate firms.
• This is a reason why firms often expand vertically
(or backward to earlier stages of production).
» If the hosiery firm buys a yarn maker, this is viewed as
backward integration, going backward “upstream” in
the manufacturing process.
Slide 27
 Dissolution
• Integration combines assets, but often conglomerate
firms find it in their interest to sell assets and to get
back to their core businesses.
• Suppose a partnership wants to divide up the assets, but
in doing so, the market may wish only to pay highly
discounted prices
• Suppose the whole firm is worth $3 million, and Joe
and Kim want to divide it.
• If both agree, the deal goes through.
• If either disagrees, the value of the whole shrinks by $1
million at EACH disagreement. What happens? Slide 28
 Dissolution of a Partnership
Figure 15.8 – Joe’s Payoffs are listed first in each pair

Offer Accepts {$900,000; $2.1 million}

to
Joe 1 Kim 1
Accepts {$500,000, $1.5 mil.}
Split REFUSES
Offer
Kim 2
Joe 2 Accepts
to {$400,000; $600,000}
REFUSES
Split
Offer
Looking to end-game reasoning, Joe 3 to Kim
disagreements end in disaster { 0, 0 }. Split 3

So, Joe offers to give Kim $2.1 million, and REFUSES

Kim will accepts it. Joe gets $900,000. { 0; 0 }
Slide 29