Ecos3003 Final Review
Ecos3003 Final Review
Ecos3003 Final Review
2
1
F i
i
O w
1 2
10 10
, 1, 2
2
i
e e
w i
2 2
1 2 1 2
10 10 S e e e e
Utility= Wage Effort Cost
Derive e
1
: 10/2 - 2e
1
=0 e
1
= 2.5
Derive e
2
: 10/2 - 2e
2
=0 e
2
= 2.5
Each worker receive half of marginal benefits of effort, but bears full marginal cost Externality
Worker going to put less effort since they cannot get full marginal benefits of effort.
MB,MC MC=2e
i
10 MB
5 MB (team)
2.5 5 e
General result: moral hazard in teams results in less than efficient effort level
Why? Because of Externality: worker cannot get full return of efforts.
Need to give each worker their full marginal benefit in order to get first best
Balance of budget: Total output = Total wage MB=MC
But budget constraint violated: not possible to give each worker full MB of effort and balance the
budget w
1
= O
F
& w
2
= O
F
w
1
+ w
2
= 2*O
F
Monitoring the monitor
Worker Manager Owner
Worker effort into production
Manager reports to owner on worker effort
Owner faces two problems
- need to motivate worker to work at appropriate level of effort
- provide manager with incentives to tell the truth ie be on the owners side (not the worker)
General problem: bureaucrat regulating firms, police etc
2 1 2
10 10
, 1, 2
2
i i
e e
U e i
1 2
10 10 , 1, 2
i
w e e i
5 i e
The trade-off between risk and incentives
Traditional trade-off: -cost of performance pay increasing with risk faced by risk-averse agent, as
need higher expected wage to compensate agent for facing uncertainty. More uncertainty
environment Less likely use of incentive contract
- trade-off for firms - benefit of more effort versus higher wage costs
Prediction: Risk imposed on workers is increasing in the uncertainty of the environment
Standard empirical prediction is that incentive pay is lower in more uncertain environments
But empirically, not convincing evidence showing relationship between pay for performance and
observed measures of uncertainty. Some measures suggest a positive relationship.
Another effect of uncertainty what project to do?
Result: Delegation (so agent decides what to work on) more likely when greater uncertainty about
what agent should be doing
Tradition model: uncertainty about relationship between effort and output
New alternative model: uncertainty about the project (What project should to do? Local agent
choose the project, principal provide incentives to do right things)
- when agent has discretion need output-based incentive pay to constrain their choice (i.e more
uncertainty, more use of output based incentive pay)
- in more certain environments, firms more able to assign tasks to workers and monitor inputs (i.e
less incentive pay)
Divisional performance evaluation:
Most organisation have some subunits grants some decision rights and evaluated on
performance (note organisational architecture performance evaluation and reward systems are
consistent with decision rights granted to unit manager)
Each unit can be characterised into 1 of 5 categories based on the decision rights it has been granted
and the way its performance is evaluated.
1. Cost centre: produce an output at minimum cost
- cost centres assigned decision rights to produce a stipulated level of output; in achieving this
units efficiency measured and rewarded
- granted decision rights for determining mix of inputs used to produce output
- managers evaluated on their efficiency in applying these inputs to produce output (not judged on
selling output, revenue, profit)
- output must be measurable
- because it retains the decision rights to specify the departments output or budget, central
management must possess the requisite specialised knowledge (understand budget constrain)
- quality must be monitored effectively
Various objectives are used to evaluate cost centre performance
(a) minimise cost: set q*, managers need to produce at min cost (choose efficient input mix)
(b) max output: max output for specified budget; same incentives, as need to select cost
minimising input mix to produce q*
(c) minimize average cost(ATC): (Note: min ATC not the same as maximising value (MR = MC is not
necessarily the same as ATC minimised) (MR=MC profit maximize)
In summary central managers need understanding of units cost structure, determine value-
maximising output level, monitoring quality and set up appropriate rewards; cost centre manager
needs specific knowledge of optimal input mix
Expense centre:
- activities such as personnel, accounting, patenting, public relations and R&D
- expense centre manager given fixed budget and asked to max output
- difference with cost centre is expense centre is output in expense centre measure more
subjectively - ie cost centre with output not easily measured
Implication users not charged directly, hence personal expense center my over-demand
- have a tendency to increase in size (centre grows faster than whole organisation)
- could use benchmarking against other firms
- reorganise under control of largest user
Revenue centres: maximize the revenue; can choose not only input mix but also output
- marketing activities of selling, distribution, servicing finished product
- regional sales manager given budget for expensies etc and has decision rights over budget to max
revenue
- consistent, if prices-budget set combination correct with value maximisation (senior manager set
the price the revenues centre maximize revenue by choose quantity)
- cannot give decision rights over both price and quantity, as set level to where MR = 0
Profit centres: max profit, more decision right
- comprised of several cost and possibly expense and revenue centres
- given a fixed capital budget and allocated decision rights for input mix, product mix and setting
prices (or output qs)
- knowledge required to make product mix, quality, price and quantity decisions specific to the
division and this info is costly to transfer
- managers rely on internal accounting systems(transfer price)to provide performance evaluation
- evaluated on difference between actual and budgeted accounting profits for their division
Investment centre
- similar to profit centres, additional decision rights for capital expenditure and are evaluated on
measures such as return on investment
- manager of unit has specific knowledge about investment opportunities as well as information
relevant for making units operating decisions
- often comprised of several profit centres
- all the decision rights of a profit centres + decision rights overamount of capital to be invested.
Two measures of performance of investment centres:
(a) return on investment % ROA opportunity cost
(b) residual income( absolute income generated)
Transfer pricing: tax saving - sell products or services between units within a firm
Transfer price price of product traded within firm (between divisions)
The choice of transfer-pricing method reallocates total company profit within business units; it also
affects total firm profits reason: - managers make decisions based on transfer price
(affect reward in 2 divisions result incentive to make real decisionaffect total profit)
- transfer price do not reflect resource values effectively, managers will make inappropriate
decisions
Set transfer price at opportunity cost of that input, marginal cost
Double marginalisation problem- In final
With costless information: - MC of producing in unit A is $3 - unit B can sell product for $5
Alternatively A could sell product in market for $6
With asymmetric information: - division manager only party who knows MC
- Output demand P = 110 5q, MC = 10
- 2 units manufacturing (MC = 10 per unit) and distribution (MC = 0)
Profit max:
Profit= (equilibrium price marginal cost) * quantity = (110 5q 10) * q
Derive q: 100 10q=0 q*=10 P*= 110 5(10) = 60
Max Profit = (60-10)*10 = 500
Now assume manufacturer sets transfer price and sells input to distribution unit for Pt, then
distribution unit sets final output price Pd (solve this problem backward)
profit A + profit B two division get reward based on maximizing their own profit
Profit for distribution = (110 5q pt: constant marginal cost for distributor)*qd
Derive qd= 110 10qd pt = 0 qd= (110 pt) / 10
Solve backward substitute qd into manufacture profit maximizing
Profit from manufactory = (transfer price marginal cost) *qd = (pt 10)* [(110 pt) / 10]
=(pt 10)*[11 (pt/10)] = 11pt (pt*pt) /10 110 + pt
Derive pt: 11 pt/5+ 1 =0 pt = 60
qd= (110 60)/ 10 = 5 pd = 110 10*5 = 85
profit for manufactory= (60 10) * 5= 250 profit for distribution= (85 60)*5= 125
Total profit for transfer price= 250+125=375 Maximum profit=500
Double mark-up problem: transfer price is too high, transfer price is the marginal cost for distributor,
and the distributor will put some margin on the transfer price (pt 60), this lead to decrease in final
quantity sold. Due to each division wants to have their margin to maximize profit. However the true
marginal cost (true opportunity cost) for the firm is 10 (not pt 60), the overall price too high lead to
hurt the total profit for the firm.
Common transfer price methods
Market based transfer prices: - measure costs and benefits or resources
Problems: typically use internal market when internal sourcing is more efficient
- measures from market not accurately reflect opportunity cost of internal production
MC transfer prices
- difficult to measure; - fixed cost recovery; - revelation of info; - non-constant MC;
- capacity? : Quality
Negotiated prices: - share spoils
Time consuming: - negotiated over P but not Q at the same time, no guarantee arrive at the Pt
(transfer price) that maximises firm value.
Transfer is marginal cost profit maximizing; - Can use a fixed fee to transfer profit.
Trade-offs in performance evaluation and accounting systems: transfer price rely on information
about cost. Although helpful for decision management, accounting systems more useful for decision
control - historical data (stop fraud theft )
Trade-off:
(1) accounting mergers not under control of those being monitored
(2) DM managers use other non-financial data, non-financial more timely and less aggressively
Must choose tradeoffs between DM and DC when setting up allowing system - ie transfer pricing
- method that most accurately reflects opportunity costs to firm might not be method that gives
internal managers the most effective incentives to max firm value
- set prices at opp cost, managers incentive to inflate prices and affect their performance evaluation
Decision management (DM) has different requirements than decision control (DC)
For example, given the reward system, transfer-pricing method that is less subject to managerial
discretion might be a more accurate method of determining opportunity costs than one
that requires managers to disclose private (non-verifiable) information
Costs and benefits of choosing between alternative firm sizes
Make or buy decision: What should a firm make and what should a firm buy? -Boundaries of firm
- Integrate backwards or upstream: a firm that begins to make its own inputs
- Forwards or downstream integration: additional finishing or marketing etc
In reality, there can be a continuum of options between:
- spot markets - long-term contracts - vertical integration
Vertical and Horizontal integration: industrial organisation reason really about market power
Vertical integration: production process or chian of input
Horizontal integration: two firm selling the same product
Strategic reasons: eliminate double mark-up problem and reduce DWL, more efficient, consumer
also better off
- Chicago School mergers efficient -Reason: vertically integration to avoid double mark-up
Manufactory (A) Retail(B) Customer
Demand curve: P = 55000-100q Marginal cost: MC= $ 5000 for A, B has no cost
A and B act as one profit maximizing firm:
Profit for joint= (55000 100q 5000)*q =(50000 100q) q =50000q 100q^2
Derive q: 50000 200q= 0 q = 250 p* = 30000
Max Profit = (30000 5000)* 250 = 6250000
Solve backward because A is forward thinking and rational, will think about B reaction
Profit for B = (55000 100q w: wholesale price)*q
Drive q: 55000 100q w = 0 qb= (55000 w)/200 Best response/reaction function for B
Back to A: profit for A = (w - 5000)*qb = (w - 5000)* (55000 w)/200
=275w (w^2)/200 + 13750000 + 25w
Derive w: =275 w/100 + 25 = 0
W = 30000
qb=(55000 30000)/ 200 = 125 units
pb= 55000 100*25 = 42500
profit for A = (30000 5000)*125 = 3125000
profit for B = (42500 30000)*125 = 1562500
profit for A + profit for B = 3125000 + 1562500 = 4688000 < profit maximizing: 6250000
A set wholesales price above the true marginal cost, B face to high cost, customer face to high price
Merger a way to overcome problem (although care needed setting transfer price)
But problem here is that we have restricted type of contract two firms can write with one another
Two-part tariff : A sells input to B at MC (of $5000) and charges a fixed fee (of $6.25m)
- vertical integration not needed to overcome double-marginalisation problem
Why does double mar-up disappear after merger?
Assume incentive problem will disappear after merger, but it is not true. Even this firm under a
common ownership, manager still needs manage sale department and manufactory section, and
manager still needs to motivate them. This may leads to two profit centres in the joint venture. If the
joint venture has two profit centres will generate problems like transfer pricing issue, which will
result the exactly double mark-up problem. Ignore incentive problem after merger.
Market power - vertical integration used to extend/maintain market power
Example: selling to two markets pain relief and cancer drug
- DryCo has input required for both drugs
- pain reliever market competitive - no close substitute for cancer drug
- MC = $10 for input
- drug company can turn 1 gram of input into either pain reliever orcancer drug
Demand: Pain relief: P = 100 5Q Cancer: P = 200 10Q
DryCo sets MR = MC
Pain relief market: MR = MC MR = 100 10Q = MC=10 Qpr=9 Ppr = 100 5*9 =55
Cancer drug market: MR=MC MR = 200-20Q = MC=10 Qc=9.5 Pc= 200 10*9.5=105
However, manufacturers will engage in arbitrage: buy at $55 and resell to those making cancer drug
for < $105
- to avoid this, DryCo can integrate forward and manufacture pain reliever
- price pain reliever at $55 in retail market and sell input at $105 in wholesale market
- arbitrage no longer possible
Note: integration forward into the cancer market does not work: must integrate lower-prices (more
elastic) market pain-reliever
Third degree price discrimination, charge one price for pain relief and other price for cancer drug, 2
downstream markets, charge higher price in relative inelastic market, lower price in relative elastic
market
Third degree price discrimination problem: arbitrage between markets, vertical integration can
overcome this problem, vertical integration forward into relative elastic market (cheaper market),
start to make the final product and sell it eliminate arbitrage.
Why do firms exist? - make or buy decision
Coase (1937): use firms for transaction when less costly than using the market
- trade-off between costs within firm with costs of market
Transaction costs in writing a contract
- world is unpredictable; - difficult to write specifics in a contract; - negotiation difficult
- therefore contracts are incomplete - if contracts are incomplete renegotiation will occur that will
involve redistribution of surplus of trade;
Specific relationship (investment are specific)
If assets are firm specific, renegotiation not likely to get a return on these assets (holdup)
- reducing externalities - coordination through the market - quality of input
Bring activity into firm to avoid costs of transaction in the market
- but why do these costs change inside the firm? Problematic transaction cost
Property-right approach: cost and benefit of asset ownership affect make or buy decision
Formally review holdup: invest renegotiation (expropriation)
The hold-up problem anticipating expropriation after investment has been sunk, will
underinvest (think back some surplus will loss after renegotiation )
More generally - firm invests, other firm/union extracts rents
Firm reduces/stops investing because of holdup as doesnt receive the full marginal benefit of
investment
- surplus generated R(i), where R > 0 and R < 0 R is function of i and also a concave function,
more investmentbigger R, diminishing marginal benefit and diminishing
- net return is R(i) i
First-best i R(i)=1 Max i: (R(i) i) R(i) 1=0 R(i)=1 solution i*
Ex ante ex post R(i) realised
Holdup - other party gets (1 ) of return (surplus), where 0 < < 1 negotiate just R revenue
- renegotiation occurs after i has been sunk, do not think sunk cost, so it is not part of the surplus
negotiated over
- 2nd party gets (1 )R(i) - 1st party gets R(i)
Ex ante return to investing party is (need to consider all costs/benefits) R(i) i
1st party (investing party) maximises return by solve backward
With holdup, profit for firm A= R(i) i
Differentiate i R(i) 1=0 R(i)=1 R(i)=1/ solution i^
First-best i: solution i* Holdup problem: R(i)=1/ solution i^
i^ < i* inefficient investment(underinvestment) because investor cannot get full marginal benefit
but bears dull marginal cost (externality)
Holdup can occur when contracts are incomplete (renegotiation) will occur and investment is
specific to another party
- location - GM-Fisher Body - Firm specific training
Hold-up : hold-
up
Boundaries of the firm - what does ownership involve?
- right to do as wish with asset when a contract does not specify what should be done
- residual right
- these rights are important when contracts are incomplete
For example, something new happens not specified in the contract that requires firm to renegotiate
- in this case the owner of the asset can say what gets done with it: this translates into more
bargaining power(bargaining power means get more surplus during renegotiation)
- more bargaining power may allow an individual to get more surplus from renegotiation
- ownership encourages investment ex ante: increase return increase incentive to invest
Costs other party does not get as much ex post surplus, so they will reduce
their investment ex ante
Property-rights model:
1 Two parties essential for trade A upstream makes input y for B downstream
2. Outside option for both parties 0 (trade efficient)
3. Only one asset (x) needed for trade to be completed.
4. A can make investment e and B can make investment i to increase value of trade (reduce the cost
of final input y)
5. Contracts incomplete; renegotiation will occur after investments have been sunk
Ex ante Ex post (contracts can be written)
Cost: e for A, i for B; sunk investment spilt surplus between parties after i and e sunk
Ex post returns (benefit and cost):
For B: benefit = R(i) + R where R(i) > 0 and R(i) < 0 greater ex ante invest, greater return
For A: cost= C C(e) where C(e) > 0 and C(e) < 0
B invests i at cost at i, A invests e at cost at e
Ex ante surplus
A: C C(e) + e B: R(i) + R i A and B: concave curve- surplus increase at a decreasing
rate e, i : sunk cost
Surplus-ea = R(i) + R i [C C(e) + e]
Ex post surplus (after i and e sunk cannot change sunk investment)
Surplus-ep = R(i) + R [C C(e)]
First-best ex ante investment (benchmark: maximum surplus)
Differentiate i R(i) 1 =0 MB =MC R(i) = 1 i*
Differentiate e *C(e) + 1+=0 MC = MB C(e) = 1 e*
Real trade-off: the asset owner have more bargaining power and willing to invest more, but the
other party does not own asset and will invest less or invest zero
Ownership important more bargaining power Assume owner of asset has all of bargaining
power and get all of ex post surplus set price P (take it or leave it offer)
A has ownership, ex post: A set price as much as buyer B willing to pay p = R(i) + R
A sets e to maximise: { price cost = R(i) + R [C C(e) + e]}
choose e to maximise {price cost} Differentiate e *C(e) + 1+=0 C(e) = 1
A will invest e*, because A bears full marginal cost of investment and also get full marginal benefit of
return, no externality, so A will put effort same as first best of ex ante investment
With A ownership, A invest e*, however, B invest ex ante, B sets i so as to maximise (benefit price)
Max : R(i) + R i [R(i) + R] Max: ( i) set i^= 0 B have no incentive to invest
Result: under A ownership B invests nothing i = 0 and A invests e*
If B has ownership, during renegotiation (ex post) B has all the bargaining power, so will set price p
at lowest level (minimum price level = marginal cost) that A is willing to still supply the good at:
p = C C(e)
Backward solve problem
Ex ante investment given the price
B max i : R(i) + R i [C C(e)] first order condition: R(i) = 1 if B own asset, B will invest i*,
because B bears full marginal cost of investment and also get full marginal benefit of return, no
externality, so B will put effort same as first best of ex ante investment.
With B ownership, B invest i*, however,
As ex ante maximisation problem: maximise price costs, or max C C(e) *C C(e)+ e
A choose e max ( e ), set e^ = 0 A has no incentive to invest
Bs maximisation problem ex ante: max R + R(i) i C C(e)
Result: A invests e = 0; B invests i*
Advantage: asset ownership gives a strong incentive to invest
Disadvantage: Real trade-off problem, other party invest zero, not max surplus, not at most
efficient level
So who should own the asset?
With A ownership Surplus for A ex ante: Sea = R i [C C(e*) + e*]
With B ownership surplus for B ex ante: Sea = R +R(i*) i* C
A ownership is better if: Surplus for A ex ante > surplus for B ex ante
R C + C(e*) e* > R + R(i*) i* - C or if C(e*) e* > R(i*) i*
This is way to increase value of trade; A should own asset when A investment is more important and
/ or A contribution is larger
B ownership better if: Surplus for A ex ante < surplus for B ex ante
R(i*) i* > C(e*) e*
This is way to increase value of trade, B should own asset when B investment is more important and
/ or B contribution is larger
Proposition: A owning the asset is (second-best) surplus maximising when As investment is
relatively more important than Bs investment (C(e*) e* > R(i*) i*)
B owning the asset is (second-best) surplus maximising when Bs investment is relatively more
important than As investment ( R(i*) i*) > C(e*) e* )
What about?
(1) Bargaining power: - provided asset ownership gives the party greater surplus, similar result holds
(2) More assets: - take 2 assets: can have separation, A owning both assets, or B owning both assets
General principles:
(a) Agent with important investment should own asset
(b) Agent who is (relatively) more responsive to asset ownership should own asset
(c) With more than one asset, complementary assets should be owned together
Summary: Asset ownership provides residual control, which in turn provides bargaining power
during renegotiation. This additional bargaining power provides an incentive to invest
- asset ownership encourages investment; - not owning an asset discourages investment
Limitation: (1) model of owner- operated firm, small firms not big corporation
(2) In reality have bargaining solutions e.g. constant return for other party
Uncertainty likely to motivate ownership of specific asset
- increases the likelihood of renegotiation
- on the other hand, in certain environments a contract can cover most contingencies, lessening the
chance of holdup
Activity frequently outsourced (long-term contract): -catering , trucking, computing services
Spot market is not appropriate, but assets are not firm specific
- Low potential for holdup - easy to write a complete contract
Specific assets
- likelihood of vertical integration increases with specificity of asset
- less specific asset, more likely market transaction or
long-term contract produce efficient investment incentives
Corporate governance
Publicly traded corporations
Corporation have the legal standing of an individual (distinct from its shareholders)
It can enter into contracts and participate in law suits
Corporations have rights to issue stock
Laws require board of directors primary decision control rights for the firm
Shareholders have limited liability (only their initial capital contribution subject to risk; they are not
legally responsible for the debts of the company)
Some corporations held closely; others publicly traded
Three types of shareholders: Small; institutional e.g. super fund ; block holders (family
hold firm share)
Stock ownership patterns
Institutional stock ownership increased
Widely held (no one owner controls more than 10 per cent of the shares), in 1995 in the US
80 per cent of the largest firms and 50 per cent of medium-sized firms were widely held
Governance objectives
Corporate governance the organisational architecture at the top of a corporation.
Focuses on the allocation of decision rights among shareholders, board of directors, top managers
and external monitors (independent auditors, regulators, stock exchanges)
Corporate governance
Governance systems evaluated to:
The motivation of value-maximising decisions
The protection of assets from unauthorised acquisition, use or disposition
The production of proper financial statements that meed the legal requirements
Separation of ownership and control
With separation of ownership and control, corporate decision makers will have weaker incentives
to use assets productively (than owner/managers)
Why use a publicly traded company then?
Top-level architecture
Organisational architecture of typical corporation does not give absolute authority to professional
managers
Decision rights divided among shareholders, the board of directors, top management, and external
monitors
Similar principle as separating decision management and decision control
Three types of shareholders: small, institutional; blockholders All have differing incentives
Board of directors
Board of directors primary function is top-level decision control (ratification, monitoring)
to provide general oversight of the corporation and to ratify important decisions
Delegates most day-to-day decisions to professional managers
Duty to shareholders
One of main tasks to monitor, compensate and, if required, replace the CEO
Board of directors
Structure of board differs depending on the legal requirements and the practical needs of a
particular firm
Some critics question the independence of boards, especially when they have limited outside
members
Top management authority and incentives
The CEOs decision authority flows from the board of directors
Most decisions are delegated further; focus of CEO more of broader corporate-level questions?
Often use a team of executives; CEO concentrates on external activities while the COO
concentrated on managing internal operations
Incentives at the top
Bebchuk and Fried (revisited)
1. Typical corporate board captured by management; 2. Better governance reduces capture; 3.
Managers want high rents (not performance-based pay); 4. Public outrage places a constraint on
excessive pay; and 5. Competition in product, labour and takeover markets limit executive pay, but
not perfectly
Empirical predictions:
Level of CEO compensation is expected to be lower in firms with better governance
Top managers expected to receive more incentive-based compensation in firms with better
governance
Firms camouflagecompensation to avoid stark disclosure (ie retirement
compensation schemes)
External monitors
External parties monitor corporate decisions
public accounting firms, stock market analysts, commercial banks, credit-ratings agencies and
regulatory authorities
For example, independent auditors bonding mechanism
But how independent are these auditors?
Similarly, stock market analysts provide information to potential investors
Ratings agencies (S&P, Moody and Fitch) rate corporate debt of large companies for default risk.
But companies pay the rating agencies to rate their debt issue. Conflict of interest?
External monitors - regulators
What is the rationale for regulation and requirements of disclosure/reporting?
What market failure are regulations correcting?
Is it possible private institutions could generate similar institutions? How to collect enough
information?
External monitors - regulators
Costs of complying with regulations significant
Benefits possible come from fostering investor confidence in system, increasing aggregate
investment (as well as investment in specific projects)
Disclosure of information could assist the market forces, particularly in the managerial and
corporate control markets
Motivating change
Leadership is more than developing a vision for an organisation
- need to motivate others to implement that vision
- firms organisational architecture can play a pivotal role
- marketing concept also important
Leaders- leading others along a way, guiding
Two characteristics of leadership: - vision or plan; - motivate people to follow that vision
Developing the vision
- organisational architecture should be designed such that it motivates employees with specific
relevant specific knowledge to initiate value-enhancing proposals
- empower employees
Motivating
- charisma , important, but employees influenced by economic incentives provided
by architecture
- implementing a new decision is often subject to self-interest within a group setting
Attitudes towards change gaining support for change
status quo on IC curve is zero
Proposal design
Maintaining flexibility:
- people more likely to suppose a new proposal if it entail lower risk
- could start with a limited pilot program (small scale)
Commitment: - strategic value of making a commitment to change
Distributional consequences: - some employees will gain, others will lose from the change
Marketing a proposal
Careful analysis and groundwork: reduce uncertainty
- risk averse individual more likely to favour status quo - communicate with employees
Relying on reputation - a leader with a good reputation is more likely to be listened
Emphasizing a crisis - argue that current situation is worse than thought, and will only get worse
Organisational (power from knowledge)
An employees attitude towards change depends on the power of the person
- to be effective it is important for managers to understand the sources of this power and how to
acquire it
Sources of power:
- formal authority; - control of budgets and resources; - control of information; - friends and allies
Power- Tying the proposal to another initiative
- claim project is integral part of project that is already approved
Coalitions and logrolling ;
- coalition of parties with differing interests that band together to support each others projects
- credibility that will support others projects in the future;
- identify potential logrollers?
- how specific should you make the proposal?
The use of symbols : - use informal methods and messages to complement formal architecture
Formal corporate plan: communicating to employees objective of organization
Opposing change
There are many examples of a union opposing a surplus-enhancing innovation or change
- print unions opposed new computer technology (UK)
- automotive union opposed new work practices & technology (USA)
- shearing unions opposed wide combs (Australia)
Reason oppose a surplus-enhancing change:
Consider a union and a firm
- the firm wants to implement a new change that will increase total surplus (a new work practice)
- there are two periods
- if the change is implemented generates v1 surplus in period 1 and v2 in period 2
- union has bargaining power, so it can effective oppose change and it can capture (at least) of the
surplus in that period, but 0 thereafter
- contracts incomplete, so it is not possible to make commitments about future periods
Second period
-If innovation has not occurred already, it will
- surplus split v2 for union; (1 )v2 for the firm is the measure of the bargaining power
If innovation had occurred in period 1, the innovation will remain, and the union will have lost all of
its bargaining power: - surplus split 0 for the union; v2 for the firm
First-period innovation
Focus on unions decision (as the firm always wishes to innovate because if firm does not innovate,
firm will gets 0)
If there is change in the first period the union gets at least: (v1 + 0)
Union know they can get v1 in period 1, but get 0 in period 2, and some compensation for loss in
period 2. (v1 + 0 + c)
Firm can use the current surplus to compensate, the maximum compensation c firm can pay is the
maximium amount of surplus: c = (1 )v1
This comes from v1 from bargaining power, and firm is willing to pay (1 )v1 as an extra
inducement to change
Outcome is union gets: v1 + 0 (this is the maximum payoff union can get)
Alternative, union did not agree in first period, union gets 0 in first period and v2 in second period
If there is no change in the first period, the payoff to the union is: (0 + v2)
Union will oppose innovation when: v1 + 0 < 0 + v2 or when > v1 /v2
No asymmetric information; No uncertainty, no risk averse; instead hold up
A union opposes change when
- there is a long-term relationship (many periods)
- innovation today affects bargaining power in the future
- future losses cannot be adequately compensated for today
- it is not possible to make promises about the future
Overcome opposition by addressing these concerns