Presentation Transcript

1. PPS231S.01Law, Economics, and Organization

   Spring 2012 III.3. Relational contracts
2. Relational Contracts Introduction Our study of contracts has so far relied on the hypothesis that wealth effects are negligible, which is required in order to apply the value maximization principle (VMP). Under the VMP, efficient arrangements are those that maximize total wealth, no matter how that wealth is shared. There are many cases, however, where the VMP does not hold because wealth effects are non-negligible.
3. Relational Contracts Introduction Ex.: Efficiency wages (Shapiro and Stiglitz, 1984), risk-neutral agents, etc. Also, if one of the parties is liquidity-constrained, distribution and efficiency may be linked (e.g., Laffont and Matoussi, 1995). Financial penalties are used much less than theory says they should (e.g., limited liability on brokers.)
4. Relational Contracts Introduction When the VMP fails to apply, the way the total wealth generated by a project is shared can affect other aspects of the transaction (e.g., who is hired, what technology is used, etc.) Ex.: In developing countries, efficiency wages may mean that workers come from wealthier families, even though poorer workers have better skills. This exacerbates income inequality.
5. Relational Contracts Introduction When wealth effects are important, a host of new questions are raised. How to provide incentives when cash penalties are impossible? How does the legal system manage the competing claims over a bankrupt firm’s resources? How is compensation determined when it may affect efficiency? How do wages and perks vary across jobs within a firm? How is competition for promotions managed?
6. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) Suppose a firm wants its employees to be on their best behavior. For example, a city may want to prevent its police officers from taking bribes. A government may want to prevent corruption among its civil servants. An oil company may want to make sure its captains remain sober. Suppose that the only effective means of penalizing employees is through termination.
7. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) The first question is whether firing someone is a sufficient deterrent for bad behavior (e.g., taking bribes, being corrupt, navigating while drunk, etc.) The answer will depend on whether the employee stands to gain from undetected cheating, how likely cheating is to be detected, what wage the employer offers, and what other market opportunities the employee has.
8. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) Let w be the wage the employee is currently paid and wo be the expected wage from another job, which takes into account the costs of looking for another job. Let g be the amount an employee could gain from cheating on the job; p be the probability of getting caught; and N be a multiplier that expresses the long-term value of this relationship, adjusting for interest and the number of time periods during which the employee is not caught cheating.
9. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) The employee will find it worthwhile to cheat if g > p(w - wo)N In other words, if the gain g from cheating exceeds the (expected) cost of cheating, the employee will cheat. The quantity (w - wo) is called the rent that the employee earns from the job, i.e., excess earnings from current job.
10. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) Note that this isn’t saying that ethics do not matter, but there is still a considerable degree of cheating going on in organizations, and this does respond to incentives. Moreover (and as always), the costs are not all monetary. It may be less costly to cheat when everyone does it. Ex.: In certain countries, marital infidelity is more widespread than in others, almost expected.
11. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) So how can an organization prevent cheating? It can most easily do it by adjusting its monitoring intensity p and the wage w it pays to make the cost of cheating greater. Or… it can increase the multiplier N by signing a long-term contract with the employee. Those are called relational contracts – they put in place a relationship between the principal and the agent.
12. Relational Contracts Efficiency Wages (Shapiro and Stiglitz, 1984) Although the above framework may seem really simple, we can get a good amount of mileage out of it. Ex.: If other firms are involved in a reputation system (multilateral punishment strategy), then wo decreases because of less employment opportunities. Or again, the firm can sign relational contracts, in which the employee stands to lose a lot of a sure thing by biting the hand that feeds them.
13. Relational Contracts Efficiency Wages vs. Incentive Payments What determines the use of efficiency wages or incentive payments? The answer is complicated, but we can sketch it out. When incentive contracts are feasible, they have been determined to be the optimal form of contract. Efficiency wage contracts are to be preferred when incentive contracts are simply not feasible.
14. Relational Contracts Efficiency Wages vs. Incentive Payments Why might an incentive contract not be feasible? When the employee cannot get by on the low wage that an incentive contract would provide if performance signals are low or to pay the fines that an optimal contract may require. Alternatively, ownership of the firm by the agent (franchising) may be infeasible for liquidity-constrained agents.
15. Relational Contracts Efficiency Wages vs. Incentive Payments Also, certain incentive schemes may require subjective performance evaluations in a way that causes problems. The employer may be tempted to underrate performance so as to reduce the pay of the employee, and so the employee becomes less responsive to incentives. Then, we have moral hazard on the part of the principal as well. With efficiency wages, the employer pays the same wage w no matter what, so that the two-sided moral hazard problem is resolved.
16. Relational Contracts Marxian View of Efficiency Wages (Bowles) Capitalists invest huge amounts in increasing p so as to pay lower wages. These monitoring expenditures are wasted resources for society. For Marxians, the factory is a wasteful system to monitor workers who could work at home. So if higher wages are paid to workers, fewer resources would be wasted. So capitalism is inefficient, sinking excessive resources into monitoring. But the argument assumes that it is possible to pay everyone a higher wage by looking at a (very) partial equilibrium.
17. Relational Contracts Read pp. 257-259 for additional aspects and applications of efficiency wage theory, viz. Adam Smith’s account of merchant honor Reputation and the Maghribi traders Career paths in firms Product reputation and brand names
18. Relational Contracts Reputations as Contract Enforcers As a lot of the previous lectures have emphasized, the reputation mechanism has long been one of the most important mechanisms for ensuring that contracts are honored (see also Fafchamps, 2004, chapters 1 and 2.) In what follows, we look at this idea in more detail, relying on elementary notions of game theory.
19. Relational Contracts Reputations as Contract Enforcers For transactions taking place over an extended period of time, there arise contingencies for which no plans had initially been made. Transactions can be classified according to how decisions are made in those cases. In spot transactions, there are no long-term agreements and little likelihood of significant changes in circumstances before the contract is executed. When the unexpected occurs, parties simply bargain over the solution.
20. Relational Contracts Reputations as Contract Enforcers Alternatively, a relational contract – for example a hierarchy or authority relation – can be established in which a manager evaluates the facts and alternative courses of action and then instructs the other parties on what to do. Sometimes, long-term contracts allow one party to exercise discretion without an authority relation. Ex.: A homeowner may delegate some authority to a contractor regarding how a remodeling job should be done.
21. Relational Contracts Reputations as Contract Enforcers Ex.: When you accept a job, you often accept to undertake some tasks within some nebulous customary limits (e.g., the party planning committee.) Disputes often arise that are connected with ambiguity about what is honest or appropriate. So let’s start analyzing the problem when even though it is not possible to specify what to do in any particular situation, it is possible for parties to determine whether the person with authority has “done the right thing.”
22. Relational Contracts Reputations as Contract Enforcers (Read the MacRents short case study, pp. 260-261.) Let’s use the following payoff matrix to describe abstractly a transaction opportunity that may occur repeatedly. At each time period, one party (the offeror) can offer to trust another (the decision maker). The following structure is the normal form game.
23. Reputations as Contract Enforcers Relational Contracts
24. Static Game Nash Equilibrium: Relational Contracts
25. Relational Contracts Repeated Dealings and Nash Equilibrium For one-shot dealings, the Nash equilibrium described above is an accurate description of what may happen, especially if temptation G and loss L are large. If the offeror and the DM meet one another frequently in this setting, however, something radically different may emerge (remember our discussion of the Folk Theorem.)
26. Relational Contracts Repeated Dealings and Nash Equilibrium Indeed, suppose that earning X at every successful dealing has the same value as a one-time payoff of NX today. The magnitude of N depends on how frequently the parties expect to meet and on the interest rates they face. By not honoring the offeror’s trust, the DM gains G immediately when he or she cheats but cannot be trusted in the future. If the DM honors trust in each period, he or she gains NV instead. So if NV > G and each party expects the other party to behave as described, then there is no gain in deviating from this (socially) optimal strategy.
27. Relational Contracts Repeated Dealings and Nash Equilibrium It is only when G < NV that trust is dishonored today. Note that the socially optimal outcome will only emerge if 1. All players have the same expectations; 2. These expectations are accurate; and 3. The players act in their best interests conditional on expectations.
28. Relational Contracts Repeated Dealings and Nash Equilibrium The problem is that several other Nash equilibria may exist. 1. Offeror never offers trust, and DM never honors it. 2. The DM cheats every second period, offeror offers trust at every period as long as DM never cheats in two successive periods. If L < V and periods are frequent, neither player can gain by modifying their strategy (modified tit-for-tat strategy.) Generally speaking, that is the problem with game theory: it leads to sharp predictions, but it often makes multiple sharp predictions between which it is difficult to discriminate ex ante.
29. Relational Contracts Repeated Dealings and Nash Equilibrium Returning to the first Nash equilibrium describe (the DM honors trust as long as the offeror keeps offering it; let’s call this the trigger strategy), note that we assumed the offeror is the same at every round. This isn’t strictly necessary. If the DM faces a series of offerors who each offer trust only if the DM honored trust the last time it was offered, then the DM’s calculation is unchanged.
30. Relational Contracts Repeated Dealings and Nash Equilibrium In this case, we may start describing the game as the DM honoring trust in order to encourage future trading partners to offer trust or to maintain his or her reputation for honesty. In business, a reputation for honesty can be valuable because it attracts trading partners. It also helps reducing contracting costs by writing simpler contracts in which enforcement is based on trust. Of course, if the DM is “patient enough” and can fool multiple trading partners for a long time, then he or she can eventually deceive everyone when it matters most.
31. Relational Contracts Such DMs, who bide their time by acquiring a reputation for honesty over a long time only to better deceive some unsuspecting offeror, are called con men.
32. Relational Contracts Ambiguity, Complexity, and the Limits of Reputation If it were easy to decide what constitutes “honorable” behavior, it would be easy for courts to settle disputes at low cost. In reality, subjective perceptions of circumstances frequently come into conflict, and parties do differ about what is the right thing to do. In many cases, it is not possible to just try out different alternatives.
33. Relational Contracts Ambiguity, Complexity, and the Limits of Reputation The problem is even worse when there is more than one party offering trust. As difficult as it may be for a single party to know whether another has acted fairly, it is even more difficult for a third party to assess what has happened. Various institutions and practices have arisen to circumvent that. Read pp. 265-269 for good examples.