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Incentives & Organization. moral hazard ownership vertical integration organizational architecture. Airbus.

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incentives organization
Incentives & Organization
  • moral hazard
  • ownership
  • vertical integration
  • organizational architecture

(c) 1999-2001, I.P.L. Png


"In the future, growth in shareholder value and efficiency can result only from an overall change in our organization. There is a need for greater centralization and central authority."

Noel Forgeard, Managing Director

(c) 1999-2001, I.P.L. Png

organizational architecture
Organizational Architecture
  • distribution of ownership
  • incentive schemes
  • monitoring systems

(c) 1999-2001, I.P.L. Png

moral hazard
Moral Hazard
  • asymmetric information about action
  • conflict of interest

(c) 1999-2001, I.P.L. Png

moral hazard in employment
Moral Hazard in Employment

employer’s marginal benefit

worker’s marginal cost

worker’s marginal benefit

Marg. cost/benefit (cents per unit)

efficient effort

Quantity (units of effort)

(c) 1999-2001, I.P.L. Png

happy coincidence
Happy Coincidence?

Between 1970-82,

  • U.S. fertility rate fell by 13.5% from 1.84 to 1.59 per hundred population
  • proportion of deliveries by cesarean section rose by 240%

(c) 1999-2001, I.P.L. Png

banking example i
Banking Example, I

*Assume zero interest rate

(c) 1999-2001, I.P.L. Png

banking example ii safe investment
Banking Example, II:Safe Investment

(c) 1999-2001, I.P.L. Png

moral hazard in banking
Moral Hazard in Banking
  • premium for deposit insurance is not experience-rated
    • riskier the investment, the greater the expected benefit for the bank owners and the higher the expected loss for the Central Bank  conflict of interest
  • Central Bank cannot easily monitor actions of the bank

(c) 1999-2001, I.P.L. Png

resolving moral hazard
Resolving Moral Hazard
  • incentive scheme
    • conditional payment
    • quota
  • monitoring system
    • incentives must be based on observables

(c) 1999-2001, I.P.L. Png

incentive vs risk
Incentive vs Risk

Efficient scheme balances

  • benefits of more effort
  • costs of risk bearing
    • degree of risk
    • risk aversion

(c) 1999-2001, I.P.L. Png

at t incentive scheme
AT&T Incentive Scheme
  • 1995: AT&T awarded CEO Robert E. Allen options for 108,000 shares at $43.94 exercise price

(c) 1999-2001, I.P.L. Png

relative performance
Relative Performance
  • employment -- promote the best worker
  • sports -- gold, silver, bronze
  • examination – grade on a curve

(c) 1999-2001, I.P.L. Png

multiple responsibilities i
Multiple Responsibilities, I


  • client engages systems integrator to implement new system
  • client concerned about
    • length of code -- easy to monitor
    • re-usability -- difficult to monitor

(c) 1999-2001, I.P.L. Png

multiple responsibilities ii
Multiple Responsibilities, II
  • strong incentive
    • more effort on that dimension
    • less effort on other dimensions
  • equal incentive principle
    • low-powered contracts

(c) 1999-2001, I.P.L. Png

non profit organizations
Non-Profit Organizations
  • school’s objective
    • maximize profit
    • maximize education of students
  • other examples – hospital, museum
  • non-profit organization to tone down profit incentive

(c) 1999-2001, I.P.L. Png

hong kong traffic wardens
Hong Kong: Traffic Wardens
  • 20-30% of vehicles at expired meters did not get citations
  • monitored traffic wardens issued 69-215% more citations
  • proposal: assign each warden a daily quota of citations

(c) 1999-2001, I.P.L. Png


When Airbus assigned A-318 production to DASA, Aerospatiale threatened to quit the consortium

  • conflict of interest
  • no asymmetry of information

(c) 1999-2001, I.P.L. Png

resolving holdup
Resolving Holdup
  • avoid specific investments
  • write more detailed contracts
  • vertical integration (redistribute ownership)

(c) 1999-2001, I.P.L. Png

floating investments
Floating Investments

How to retrieve investment in politically unstable country?

  • Saigon Floating Hotel
  • floating power plants in Philippines

(c) 1999-2001, I.P.L. Png

complete contract
Complete Contract
  • specifies actions and payments in every contingency
  • degree to which a contract should be complete
    • potential benefits and costs at stake
    • extent of possible contingencies

(c) 1999-2001, I.P.L. Png

rick schroder nypd blue contract
Rick Schroder: NYPD Blue contract

“You may be required from time to time to show the buttocks. No genitalia will be shown.”

(c) 1999-2001, I.P.L. Png

imco s saginaw plant
IMCO’s Saginaw Plant
  • IMCO built new $22 million aluminium plant in Saginaw, MI – three miles from GM casting plant
  • GM contracted to buy over $1 billion of aluminium from IMCO over 13 years

(c) 1999-2001, I.P.L. Png


Residual rights

  • control -- rights that have not been contracted away
  • income -- remaining after payment of all other claims

(c) 1999-2001, I.P.L. Png

saigon floating hotel
Saigon Floating Hotel
  • 1987: built in Singapore
  • 1987-89: Great Barrier Reef, Australia
  • 1989-96: Saigon River
  • 1996: Vietnam Government refused to renew operating license

(c) 1999-2001, I.P.L. Png

vertical integration
Vertical Integration

Combination of assets for two successive stages of production under a common ownership

  • upstream: away from final consumer
    • Dominion Resources acquired Consolidated Natural Gas, 1999
  • downstream: closer to final consumer
    • Phillips Petroleum acquired Tosco, 2001

(c) 1999-2001, I.P.L. Png

vertical integration impact
Vertical Integration: Impact


  • gets rights to residual control and residual income
  • reduces potential for holdup

(c) 1999-2001, I.P.L. Png

make or buy
Make or buy?






moral hazard

internal monopoly

scale economies

(c) 1999-2001, I.P.L. Png

airbus production i
Airbus: Production, I
  • annual “poker game”: consortium fixed transfer prices with partners
  • partners received proportionate share of consortium profit
    • Where was partner’s incentive greater -- for self or Airbus?

(c) 1999-2001, I.P.L. Png

airbus production ii
Airbus: Production, II

“It was quite a dishonest system… Each partner’s prime motivation was to look after its own interest.”

Mike Turner, Airbus Board Member

(c) 1999-2001, I.P.L. Png

airbus production iii
Airbus: Production, III

“Airbus Industries’ production system is one of the most efficient – and flexible – in the world. Approximately 96 percent of the aircraft work is performed in plants operated by the partner companies.”

Airbus: Corporate Overview, Dec. 1999

(c) 1999-2001, I.P.L. Png

corporate governance
Corporate Governance
  • monitoring -- Board of Directors, major shareholders
  • incentives -- stock options, bonuses, profit-sharing
  • ownership -- proxy fight, takeover

(c) 1999-2001, I.P.L. Png

gillette october 2000
Gillette, October 2000

Gillette fired CEO Michael C. Hawley

  • Warren Buffett: “We thought there was someone better to do the job”
  • shares rose 15%  market capitalization increased by $4 billion

(c) 1999-2001, I.P.L. Png