Behavioral Economics, Contracting Costs, and Organizational Architecture

Alternative Models of Behavior

_(1.2)

Money Matters

• Reductionist and simplistic model: “Everything and everyone has a price” – the “economic model” is richer and more subtle than this.
• The only component of a job is monetary compensation.
• Therefore, anyone can get anybody to do anything for sufficiently high compensation; the economic model cannot guarantee that! (Easy job life and poor results)

Happy-Is-Productive

• Employee satisfaction and happiness is not a means in itself but rather instrumental to firms’ goals.
• It is the view of managers who believe that “happy employees are more productive”.
• In this way of thinking, employees exert higher effort and dedication in the job not when they are better paid, but when they feel better treated.

Decision-Making Under Uncertainty

_(1.3)

Describing Risky Outcomes

• Lotteries and Probabilities: A lottery is any event with an uncertain outcome. A probability of an outcome (of a lottery) is the likelihood that this outcome occurs.

Evaluating Risky Outcomes (with example)

Calculating the variance and the expected value of both of them. The Expected Value (EV) is the same (100), but the variance of internet is 240 and of auto is 80. So auto has a lower risk.

Contracting Costs

_(3.3)

In practice, many important contracting costs exist; it is not so easy to agree on and sign a contract.

The main sources of contracting costs are:

• Costly Contracting: Contracts are costly to negotiate, write, and administer. Examples: Registry, Notary.
• Asymmetric Information: Parties to a contract have asymmetric information on performance levels. Examples: Second-hand market for cars; Renting a flat. One party knows more than the other.
• Opportunistic Behavior: Parties want to exploit their perceived advantages. Example: Bargaining over wages.

Agency Model

_(3.2)

There are two parties:

• The principal: Has formally the “power”. Examples: The owner, the boss, etc. But needs to delegate some tasks.
• The agent: Who is supposed to do the job delegated by the principal. Examples: Workers, secretary, manager.

The principal contracts with an agent for service.

Examples of agency relationships (all of this should be regulated by a contract): The principal should put the right incentives in place for the agent.

The 3 Main Determinants of Organizational Architecture

₍₄₎

1. Decision-Right Assignment: Who Decides What? The CEO decides who decides what.
2. Performance-Evaluation System: What are “good” and “bad” results? If we look at the profits to determine if good performance is when the profits are higher than the profits of the industry, and the other way around. But I don’t know the profits of the others. So it is really difficult to determine good and bad performance.
3. Reward System: How are “good” (and “bad”) results rewarded? What are the consequences of performance?

The Two Parts in the IBM-Kodak Outsourcing Contract

_(5.2)

Win-win: Kodak would reduce transaction costs and IBM would win a new customer. (Kodak asked IBM to do it because it's cheaper; they are specialized in it). It seems to be win-win; IBM wins a client and profits, and Kodak wins time and is earning money; the cost of paying IBM is lower than the cost of doing it itself. In the end, Kodak forgets its own data processing capacity, so after 10 years, the situation is not equal; IBM has superior capacity to Kodak. If you outsource without being very careful, you end up being a prisoner of IBM.

Hold-Up Problem

The hold-up problem is a situation where parties may be able to work most efficiently by cooperating but refrain from doing so because of concerns that they may give the other party increased bargaining power and thus reduce their own profits. When party A has made a prior commitment to a relationship with party B, the latter can hold up the former for the value of the commitment. The hold-up problem leads to severe economic costs and might also lead to underinvestment.

Hold-Up Problem Effect on Transaction Costs

• The hold-up problem raises the cost of transacting exchanges.
• Contract negotiation becomes more difficult.
• Investment may have to be made to improve the ex-post bargaining position.
• Potential hold-up can cause distrust.
• There could be underinvestment in relation-specific assets.