Organizational Form, Governance and Mechanism Design 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. Goods are allocated in free markets by using prices. • However, there are alternative allocative mechanisms that are adopted, such as waiting in line (queues) and auctions the avoid prices. 2002 South-Western Publishing
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 suboptimal; that is, it is not value maximizing. The cooperative solution sometime yields better payoffs. • To get to a valuemaximizing solution, the manufacturer may have to consider side payments or credible commitments to the retailer. Slide 2
Choice of Organizational Form • A reliant asset is a nonredeployable durable asset. Specialized equipment or specialized knowledge cannot be transferred to other uses. • In markets with reliant assets, one party could “holdup” the other party. The choice of organization will require explicit contracts. • The likely outcome is franchise contracts. • Relational contracts are promissory agreements of coordinated performance. A jet charter company is a good example. Slide 3
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. Slide 4
Vertical Integration • An alternative to contracts between two parties is vertical integration. If the retailer and manufacturer merge, then both interests are reflected in a decision whether or not to advertise or expand service. • Spot markets present few incentive or informational problems. » 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. » The products are relatively standardized and sold for immediate delivery. Slide 5
Governance Mechanisms and the Problem of Moral Hazard • Establishing a price for a product or service in a market involves a cost. • Transaction cost economics involves the issue of finding the lowest cost organizational structure. » In some cases it is cheapest to vertically integrate and avoid markets. » In other cases, firms create quasiprices, known as transfer prices, to create marketlike pricing in a multidivisional firm. » Still others find that market relationships work best, by buying and selling at arm's length prices. » When only incomplete contracts are possible, it is often the best to integrate the operations within a firm. Slide 6
Moral Hazard • Moral hazard occurs when parties change their behavior due to contracts. This is especially true when the people's effort is hard to observe. • Consider a borrowerlender contract. » A reliable borrower, once given money in a loan, may elect to invest in high risk projects. » To avoid this moral hazard, the bank may insist on costly monitoring or governance actions, forcing the borrow to submit frequent financial data. Slide 7
An Optimal Design Mechanism • What is the best way to • Fair division of a divide a deceased decaying prize problem. individual’s estate? • Suppose the division of • What mechanism will an award between two encourage open parties shrinks each time communication and a fair one party refuses the division? agreement. • These are the types of • The incentive is created issues discussed in finding to agree to a 50:50 split; an optimal design. otherwise, the prize may get smaller. Slide 8
The Service Queue Problem: Customers Wait in Line
• Firstcome, firstserved The people with the lowest cost of time get the tickets. • Lastcome, firstserved removes the incentive to wait in line. The best strategy is to show up anytime, whenever the ticket window is open. • Stratified lotteries advanced reservation tickets are assigned different prices than last minute walkups. Slide 9
Auction Design and Information Economics • Simultaneous bidding open outcry at estate auctions. Information about other bidders valuation is revealed
• Bid prices can be discrete or continuous by agreed increments, as in 1/8 or 1/16 for stocks in the past or any decimal price now. » price discovery occurs • Bids can be sealed or posted sealed bids make • Sequential bidding them anonymous and secret such as private placement to other bidders for newly issued securities. • Bids can be onetimeonly or multiple rounds. Slide 10
Types of Auctions • In English auctions, the prices rise as more bids arrive. • In Dutch auctions, a high price is announced, and if no one agrees, the auctioneer lowers the price until the first bid arrives. » If mineral rights to 1,000 acres of land were auctioned, the winning bid may elect to purchase less than 1,000 acres or rights. • Reservation price the minimum acceptable bid. Slide 11
Winner’s Curse • If the true value of an item is not known, but bidders have a distribution of values that they are willing to pay, the winning bid is very likely to be higher than the true value. • The regret for the bidder is that he or she paid too much: the winner’s curse. • If everyone is aware of the winner’s curse, then all would bid less than what they think is its true value. This problem has led some auctions to award the highest bidder with the secondbest price in a sealed bid auction. Even though you won, the price was a bit lower than what you paid. Slide 12
Information Revealed in CommonValue Auctions • Commonvalue auctions are ones where the bidders have identical valuation of the item when information is complete. • For simultaneous, sealedbid auctions, the bidder offers prices below their expected value. » No information is conveyed to competitors. • For simultaneous, openbidding auctions, information is revealed by the bids of others. One variation is multiple rounds. • Bidding for broadcast spectrum bidding, the FCC used 112 rounds over a fourmonth bidding period. Slide 13
Strategic Underbidding in PrivateValue Auctions • Privatevalue auctions are • where bidders have different valuations for the item • The highest value bidders may • wish to waitandsee in English • open outcry auctions.
A Vickery auction is the secondhighest sealed bid auctions. Secondhighest sealed bids are used to reduce underbidding. Knowing that you pay less than bid helps to move bid closer to • In sealedbid auctions, this one’s private value. strategy does not work. • As the number of bidders rises, • Even with sealed bidding, the the percentage underbid tends to fear of the winners curse may decline. lead to underbidding. • Vickery shows the optimal underbidding is 1/Nth the true value, with N the number of bidders. Slide 14