D. A Supply Contract. (An expanded version of Problem 7) Firm S is
about to contract to deliver lumber to Firm B. Firm S estimates that under
normal circumstances, it can produce and deliver the lumber at a cost of
$100,000. In recent months, however, the firm has been troubled by partial
work stoppages. Should such stoppages recur, a portion of the lumber to
fulfill the contract would have to be shipped from distant mills, increasing
the total cost to $400,000. In the event of a labor strike, all of the order
would have to be supplied by other mills, increasing the total cost to
$600,000. Management of Firm S believe there is an 80% chance of normal
labor conditions, a 10% chance of a partial stoppage, and a 10% chance of a
strike. Thus, Firm S’s expected cost of fulfilling the contract is:
(.8)(100,000) + (.1)(400,000) + (.1)(600,000) = $180,000.
Firm B must have the lumber by the first of the month to fulfill a
construction job that is expected to bring $480,000 in gross profit. In
addition, the firm is about to spend $100,000 in setup costs for the
construction job. If Firm B does not receive the lumber on time, it must
forfeit the job. In short, timely delivery of the lumber by Firm S spells the
difference between $380,000 in net profit for Firm B or a $100,000 loss.
The two firms are considering three different types of contracts:
Specific Performance. The seller is required to deliver the lumber on time.
Reliance. A seller who defaults (fails to deliver on time) must pay back any
money he has received from the buyer (the price $P) and must compensate
for the buyer’s “reliance,” Firm B’s lost $100,000 investment.
Expectation. The defaulting seller must pay the buyer its “expectancy,” the
profit expected under the contract. (If it defaults, Firm S would keep the
contract price $P but must pay back $480,000 to Firm B.)
Question for the class: Which type of contract is most effective in
providing the right incentives for Firm S?
Answer. This is an interesting principal-agent example dealing with
incentives. As will be duly noted in Chapter 15’s discussion of negotiation,
the two sides should reach a mutually beneficial contract. After all, Firm S’s
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expected cost is $180,000 and Firm B’s net profit is $380,000. There is plenty
of room for a mutually beneficial price in between. Consider each of the
contracts in turn.
Under specific performance, delivery is mandatory. If the negotiated price
were (say) $280,000, then Firm B’s profit would be 380,000 – 280,000 =
$100,000, and Firm S’s expected profit would be $280,000 – $180,000 =
$100,000. The combined profit is $200,000.
Under reliance, Firm S would choose to default if there is a partial stoppage
or a strike. By defaulting, it must pay back $280,000 + $100,000 = $380,000
which is cheaper than delivering at a cost of $400,000 or $600,000. Firm B’s
expected profit is (.8)(100,000) = $80,000. (Firm S defaults 20% of the time,
forcing Firm B to forfeit the building contract and leaving it with zero profit.)
Firm S’s expected profit is:
(.8)(280,000 – 100,000) + (.2)(-100,000) = $124,000.
Thus, the combined profit is $204,000.
Under expectation, Firm S would choose to default only if there is a strike.
By defaulting, it must pay back $480,000 (it keeps the $280,000 contract
price) which is cheaper than delivering at a cost of $600,000. Firm B receives
a guaranteed profit of $100,000. If Firm S defaults (when there is a strike), it
must forfeit the construction contract but it is indemnified $480,000 by Firm
S. Its profit is: 480,000 – 280,000 – 100,000 = $100,000. Firm S’s expected
profit is: 280,000 – [(.8)(100,000) + (.1)(400,000) + (.1)(480,000)] =
$112,000. Thus, the combined profit is $212,000.
Of the three options, the expectation contract is most efficient; it generates
the greatest total profits to the parties together. It ensures that delivery is
made in the “right” circumstances: under normal work conditions or partial
stoppage. The buyer’s benefit from delivery is always $480,000 (the
$100,000 setup cost is already sunk). Thus, it is efficient to deliver when the
supply cost is $100,000 or $400,000. But, delivery is inefficient when the
supply cost is $600,000 (i.e. exceeds the buyer’s $480,000 gain). By
penalizing the supplier an amount that reflects the buyer’s gain, the
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expectation contract gives the supplier exactly the right incentive whether to
fulfill or default the contract. (This is akin to taxing the generator of an
externality for the harm caused.)
The contract calling for specific performance is inflexible. It requires
delivery in all cases, even when it is inefficient (during a strike). In this case,
the supplier’s cost ($600,000) exceeds the buyer’s gain ($480,000). Delivery
implies a net financial loss of 600,000 – 480,000 = $120,000. With a strike
10% likely, the expected net loss is (.1)(120,000) = $12,000. Thus, specific
performance reduces the parties’ total profit (relative to the expectation
contract) by $12,000 ($200,000 compared to $212,000).
Finally, the reliance contract provides an insufficient delivery incentive. As
we saw, Firm S defaults even during a partial work stoppage. (It is cheaper
for it to default than to deliver.) But delivery should occur because the
buyer’s $480,000 gain exceeds the seller’s $400,000 cost. By not delivering,
the parties are forgoing a $80,000 combined profit. With a work stoppage
10% likely, the expected profit forgone is (.1)(80,000) = $8,000. Thus, the
reliance contract reduces the parties’ total profit (relative to the expectation
contract) by $8,000 ($204,000 compared to $212,000).
B. Organizational Design
In teaching this section, we suggest starting with the big picture:
The essence of the modern firm is the division of information and
management responsibilities among a wide group of managers.
Today’s firm is a set of agreements and contracts, both explicit and
implicit.
We then go on to describe the boundaries of the firm, the division of decision
making responsibilities, and the workings of incentive systems. Many of the
short readings listed on the next page provide real-world applications of
these principles. For instance:
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On dividing responsibilities:
The back-of-chapter discussion question highlights different division
structures. In turn, the two Honda readings recount how the company
changed from a consensus–building decision approach to a centralized
approach. (By contrast, the “bread-store” article emphasizes the virtues of
decentralized decisions.) An instructor who wants to spend more time on
issues of centralization and decentralization might also wish to use the
Harvard Business School Case, DHL Worldwide Express, 1997 (in the listing
of cases). The text contains a capsule summary of this case. The readings
section also includes three interesting articles on the benefits and costs of
teams.
On incentives:
In an effort to minimize costs, many firms have increasingly turned to
piece-work compensation systems, where compensation is paid according to
job outputs. (See the article, “Paid by the Widget and Proud.”) For instance,
the instructor might raise the following simple example. Should a typist
(word processing worker) be paid a fixed salary? Should he be paid based on
hours spent on different jobs? Should he be paid by the number of pages
produced? How might pages of ordinary typing be compared to pages of
difficulty, technical typing? Should compensation be based on some
combination of the above factors?
Incentives are also the subject of the short readings: “Risky Business …”,
“Executive Pay”, and the two pay-for-performance readings.
Finally, the article, “Plan to go Public at Goldman, Sachs,” describes the
decision by the last major investment firm to abandon the partnership
structure in favor of the corporate form that separates the components of
ownership and control.
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ADDITIONAL MATERIALS
I. Short Readings
L. Stevens, “For FedEx and UPS, a Cheaper Route: the Post Office,”
The Wall Street Journal, August 5, 2014, p. B1.
S. Ovide, “A Price War Erupts in Cloud Services, The Wall Street Journal,
April 16, 2014, p. B1.
S. Mullainathan, “When a Co-Pay gets in the Way of Health,” The New York
Times, August 11, 2013, p. BU6.
J. D. Rockoff and H. Plumridge, “Drug Firms Curb Ties to Doctors, The Wall
Street Journal, December 18, 2014, p. B3.
S. Perman, “For some, Paying Sales Commissions no Longer Makes Sense,”
The New York Times, November 21, 2013, p. B4.
J. Carreyrou, “Study: Surgery Rate Higher When Implants Purchased From
Doctors,” The Wall Street Journal, October 26, 2013, p. A21.
“Corporate Governance: The Shareholder Awakens,” The Economist, April 9,
2011, p. 71.
V. O’Connell, “Law Firms Feel Pinch,” The Wall Street Journal, March 10,
2011, p. B8.
P. Orszag, “Malpractice Methodology,” The New York Times, October 21,
2010, p. A31.
A. Gawande, “The Cost Conundrum,” The New Yorker, June 1, 2009, pp.
36-44.
S. Covel, “Firms Try Alternatives to Hourly Fees,” The Wall Street Journal,
April 2, 2009, p. B1.
“Restraints on Executive Pay,” The Economist, May 30, 2009, pp. 71-73.
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D. Owen, “The Pay Problem,” The New Yorker, October 12, 2009, pp. 58-63.
D. Leonhardt, “When Trust in an Expert is Unwise,” The New York Times,
November 7, 2007, pp. C1, C9.
E. White, “How a Company Made Everyone a Team Player,” The Wall Street
Journal, August 13, 2007, p. B1.
“EADS: Peace on the Rhine,” The Economist, January 1, 2011, p. 58.
D. Gauthier-Villars, “EADS Considers a Simpler Management Structure,”
The Wall Street Journal, July 9, 2007, p. A3.
B. Worthen, C. Tuna, and J. Scheck, “Companies More Prone to go Vertical,”
The Wall Street Journal, December 1, 2009, p. A1.
“The Business of Making Money: Public versus Private Equity,” The
Economist, July 7, 2007, pp. 68-70.
J. Lublin, “Ten Ways to Restore Investor Confidence in Compensation,” The
Wall Street Journal, April 9, 2007, p. R1.
J. Madrick, “Where Economists Stand, or Don’t Stand, on the Issue of
Corporate Scandals,” The New York Times, October 28, 2004, p. C2.
R. Lieber, “New Way to Curb Medical Costs: Make Employees Feel the
Sting,” The Wall Street Journal, June 23, 2004, p. A1.
B. Davis, “Finding Lessons of Outsourcing in 4 Historical Tales,” The Wall
Street Journal, March 29, 2004, p. A1.
“At Shell, Strategy and Structure Fueled Troubles,” The Wall Street Journal,
March 12, 2004, p. A1.
B. Mohl, “Amtrak Satisfaction Guarantee was Doomed from the Outset,”
The Boston Globe, November 3, 2002, p. M8.
H. R. Varian, “If there was a New Economy, Why wasn’t There a New
Economics?” The New York Times, January 17, 2002, p. C2.
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“The Lemon Dilemma,” The Economist, October 13, 2001, p. 72. (George
Akerlof, Michael Spence, and Joseph Stiglitz shared the 2001 Nobel Prize in
economics for their pioneering work in asymmetric information.)
“Risky Business: A Set Fee for Each Patient Gives Doctors More Control
and More of a Financial Stake,” The New York Times, May 30, 1998, p. D1.
“Levi’s Factory Workers are Assigned to Teams and Morale Takes a Hit,”
The Wall Street Journal, May 20, 1998, p. A1.
“Heinze CEO to Tie Managers’ Pay to Performance to Boost Efficacy,” The
Wall Street Journal, June 16, 1998, p. B4.
“Boeing Links Managers’ Stock Options to Five-Year Performance of
Shares,” The Wall Street Journal, February 26, 1998, p. B12.
II. Longer Readings
S. N. Kaplan, “Executive Compensation and Corporate Governance in the
U.S.,” Journal of Applied Corporate Finance, Spring 2013, pp. 8-25.
K. J. Stiroh, “Playing for Keeps: Pay for Performance in the NBA,
Economic Inquiry, vol. 45, 2007, 145-161.
Symposium on Sociology and Economics, Journal of Economic
Perspectives, Winter 2005, 3-86.
B. Hall, “Incentives within Organizations,” Harvard Business School Case
(9-904-043), January 9, 2004.
J. G. Riley, “Silver Signals: Twenty-Five Years of Screening and Signalling,”
Journal of Economic Literature (2001), 432-478.
P. F. Levy, “The Nut Island Effect: When Good Teams Go Wrong,” Harvard
Business Review, March 2001, pp. 5-12.
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E. Brynjolfsson and L. M. Hitt, “Beyond Computation: Information
Technology, Organizational Transformation, and Business Performance,”
Journal of Economic Perspectives, (2000), 23-48.
E. P. Lazear, “Performance Pay and Productivity,” American Economic
Review, December 2000, 1346-1361.
Symposium on the Firm and its Boundaries, Journal of Economic
Perspectives, 12, Fall 1998, 73-150. (These are 4 articles by eminent
economists.)
A. Shleifer and R. W. Vishny, “A Survey of Corporate Governance,” Journal
of Finance (1997), 737-783.
Michael C. Jensen and William H. Meckling, “Theory of the Firm:
Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of
Financial Economics, 3 (1976), 305-360.
III. Recommended Cases
Henderson Global Investors, (UVA-F-1330), Darden Business School,
University of Virginia, 2001.
Scope of the Corporation (9-795-139), Harvard Business School, 1995.
DHL Worldwide Express (9-593-011), Harvard Business School, 1997.
Teacher’s Note (5-594-094).
Microsoft in the People’s Republic of China (9-795-115), Harvard Business
School, 1995. Teacher’s Note (5-796-072). (Should Microsoft make its own
local investments or should it contract out to local software vendors?)
IV. Quips and Quotes
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The secret of management is to keep the guys who hate you away from the
ones who are undecided. (Baseball manager Casey Stengle)
Most organizations can’t hold more than one idea at a time.
In a hierarchy, every employee tends to rise to the level of his incompetence.
(L.J. Peter)
Don’t ask the barber whether you need a haircut.
The real objective of a committee is not to make a decision but to avoid it.
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