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III. Decision Making
Applications
A. Asymmetric Information and
Organizational Design
1. Asymmetric information
- One party knows more than another
a. Adverse selection
- One party has hidden or
unobservable information
Ex. - Health insurance
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Ex. - Used cars
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b. Signalling
- Uninformed party tries to acquire
information about different risk categories
Ex. - High risk vs. low risk drivers, bad
vs. good credit risks, inspection by mechanics
- Low risk informed party needs to prove
status or suffer consequences of adverse selection
(1) Reputation
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(2) Guarantees or warranties
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(3) Education as a signal of worker
productivity
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- Cost of signalling should be lower for
high-quality entities for it to work
c. Moral hazard
- Agent - takes action that affects
another
- Principal - affected party
Ex. - Physician-patient, supplier-buyer,
management-stockholders
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- Moral hazard - agent has
incentives to act in its own self-interest, against the
interest of principals
Ex. - Health insurance
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Ex. - Federal Deposit Insurance
Corporation (FDIC)
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2. Organizational design
a. Breadth of firm
- Should activity be done in-house or
should it be outsourced?
(1) Factors favoring in-house
production
- Firm-specific good or service
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- Outside risks - input quality, supply
disruption
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- High degree of coordination required
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(2) Factors favoring outsourcing
- Standardized good or service
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- Competitive market available
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- Low degree of coordination required
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b. Assigning decision-making
responsibilities
- Assign decision responsibilities to those
with the best information on which to act
- Responsibilities typically divided along
functional lines, product lines, customer type, geography,
etc.
(1) Factors favoring centralization
of decision making
- High degree of coordination required
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- Concentration of decision-relevant
information
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- Significant principal-agent problems
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(2) Factors favoring
decentralization of decision making
- Low degree of coordination required
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- Dispersion of decision-relevant
information
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- Compatible interests and objectives
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c. Monitoring and rewarding
performance
(1) Motivating workers
- Worker = agent, employer = principal
- Need to get workers to give optimal
effort, given that they may prefer to do other things
(a) If effort or output are
observable, then an optimal contract can be implemented
Ex. -
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(b) If effort and output are both
imperfectly observable, moral hazard may result in less than
optimal situation
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(3) Use incentive contracts to
deal with moral hazard
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(2) Evaluating individual
performance
- Informative principle - all (and
only) information bearing on an individual's effort and
contribution to profit should be included in measure of
performance
- Problems:
(a) Difficult to identify
contributions of an individual worker
(b) Imperfect performance
measurement reduces incentives for efficient behavior
(c) Aggregate measures means
individual workers affected by performance of others
(d) Benchmark problem - how to
determine if goals are realistic
(3) Evaluating group performance
- Encourages cooperation and teamwork
- Employee rewards dependent on others
- Free rider problem - incentive
not to make full contribution, especially if individual
effort is not easily observable
- More incentive to free ride the larger
the group
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d. Impact of information technology
(1) External transactions less
costly => more outsourcing
(2) Improved Internal information
sharing => fewer hierarchical levels, more longitudinal
organization structure
(3) More decentralization of
decision making
e. Separation of ownership and control
in corporations
- Shareholders (principals) have little
control over selection of management (agents)
- Difficult for shareholders to take
actions
(1) Limiting the power of top
management
- Shareholder empowerment - binding
shareholder resolutions, reduce costs of shareholder
challenges, encourage cooperation among large institutional
shareholders
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- Corporate governance reforms - more use
of outside directors
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- External enforcement of managerial
duties - civil or criminal actions
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- Market for corporate control - market
pressures force maximization of firm values or company will
be taken over
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(2) Financial incentives for
management
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