Chs 1-3 BSZ: Basic Economic and Organizational Concepts

BEM 146, Prof Camerer

Updated 11/19/03

Chs 1-3 BSZ: Basic economic and organizational concepts

Organizational architecture:

• Decision rights
• Rewards (incentives)
• Performance evaluation

Example: Nick Leeson bankrupted Baring's Bank (-$1.5 billion). Why?

Suppose to be doing arbitrage (buy low/sell high simultaneously in Osaka/Singapore; so common movements cancel out)

Actually "plunging" on stocks, buying "naked"/unhedged (without selling)

How did he get away with it?

Poor architecture: Most firms, traders have decision right on what to trade

Back office workers have decision right on overseeing paperwork

Traders rewarded bonuses for performance (numerical evaluation) incentive to take huge bets; if they lose, don't have to pay

Ch2Marginal analysis (water vs diamonds, work vs. play)

Opportunity cost (e.g., NBA underachievers study)

Utility, constraints

Theories of worker motivation:

Money (not everything...but does not "satiate" and most uniform across people)

(why important? Often misunderstood-- parking, tax incidence, journal$)

Job satisfaction (link to productivity is weak or zero: Happy workers might be goofing off ("shirking"), productive workers might appear unhappy-- e.g., weightlifter, workaholic, Monica Seles grunting)

Citizenship "gift exchange" (reciprocity) model

Traits (loyal, tolerant of ambiguity, extroverted,…), person-job matching

(e.g. match sociopaths to CIA assassin jobs, sadists to prison guards, extroverted go into sales, etc. )

Which theory is right? Money, reciprocity, traits are all part of the story. Job satisfaction is relevant if it leads to compensating differentials (eg. if making a job fun reduces how much you can pay or adds value that customers appreciate, e.g. in service industries)

[Note: BSZ take the stand that money is easy to change or manage and others aren't; but not that if other forces can be understood they are cheap!]

(Ithaca farm stand story: Box with a slit, honor system paying, but box nailed down and the table is heavy). Sam Walton (Walmart): "Trust people, then keep an eye on them."

Property rights:

Use right vs alienability (selling right)-- body parts, apartment rental

In developed economies property rights are enforced by customs and courts. They are missed when they're absent-- Zimbabwean resettlement; "tolerated theft" (school bullies); Russian "deprivatization".

And sometimes in dispute: Kobe quake rebuilding; sports team "eminent domain" (Barry Bonds 73rd baseball case-- does 1st or last guy to touch the ball own it? Finders,keepers vs `first clear display')

Specialization, gains from trade, comparative advantage

People are good at different things (genetics + "learning by doing")

Specializing and trading can make everyone happier

(old joke: Heaven is French chefs, Italian lovers, German mechanics, Swiss bankers, British police; Hell is Italian bankers, Swiss lovers, French mechanics, British chefs).

"Comparative advantage" is relative specialization (absolute) advantage-- everyone has one!! E.g., the fastest typist in a small town with one lawyer should be a lawyer; the slower typist should type (opportunity cost of the lawyer typing is too high).

Planning vs decentralization

Old (now resolved?) debate: Can centrally-planned economies operate more efficiently than laissez-faire decentralized ones? Most evidence suggests that central planning is worse, as judged by consumers. Possible exceptions: Targeted industries in “Seven Tigers” in Asia (Korea in technology, Japan).

Central planning: An agency orders state-owned factories to produce a certain amount of goods-- say bread (perhaps informed by surveys of public demand, perhaps by fiat or whim). A price is fixed by the agency. Goods are produced and sold at the fixed price.

Apparent advantages: Price stability. Governments can guarantee that prices do not fluctuate. But! If there are fluctuations in demand how are goods rationed (e.g. if demand goes up)? Typical answers: Nepotism (friends get bread first); queues (lines); bribes. Full employment. Government employs everybody. Low prices. Can be set low (i.e., factories run at a loss) through cross-subsidy, taxation, or inflation.

Planners may get poor signals about whether to make more or less bread, and perhaps poor signals about quality. Factory managers have no direct (reward) incentive to earn more profit. Workers have no direct incentive to work hard.

Decentralization. Nobody in the government cares about bread. Firms are allowed to spring up and bake bread and sell it however they want. If they make too much they lose money. If the bread is popular and lines form, they make more or raise the price. If bread machines become more efficient workers lose their jobs; they hopefully find more productive employment elsewhere (as personal trainers?)

Another example: Claiming races for horses.

The public likes competitive races (bet more when odds are close). How to arrange them?

Obvious, not-so-great idea: Somebody at the racetrack knows all the horses and asks around, and puts them in races together.

Good idea: Announce a race for $20,000 purse and $20,000 claiming price. If horses are entered they can be claimed (bought) by anybody for $20k. Horses worth more than $20k won't enter. Bad ones won't either (too expensive to race in a hopeless race).

Third example (BSZ p 56): Public vs privately organized adventure expeditions (North Pole, Northwest Passage 1818-1909):

Public(n=35)private (n=56)

Crew deaths8.0%6.2%

# of ships (# lost)1.63 (.53)1.15 (.24)

scurvy46.7%13.2%

Why? Public had worse leaders, adapted slowly to new info

Contracting costs and firm boundaries

Why are there companies at all?

Example: Imagine "unbundling" universities: Students pay separately for janitors, dorms, teaching, seats, building rental, computer services, food…Faculty rent space, earn revenue from teaching and grants, pay for phone, Xeroxing, etc.

Too many headaches!

Firms economize on "contracting costs" (Coase, 1937)-- finding out prices, assuring quality (reputation), transferring money, creating a long-lived "repository of reputation" (“Caltech” reputation outlives its faculty, students etc) etc.

"Like coagulated lumps in a pail of buttermilk"

Many interesting hybrids:

Food court (e.g., Singapore night market) vs restaurant (buy "parts" of a meal separately)

Malls vs department stores

European store-by-store shopping vs supermarket

Wedding planner: Hire somebody to hire other people

Building contractors: Hires labor for you

Key distinction: Who has "residual decision rights"?

(I.e. right to decide what to do if the contract doesn't specify it)

Markets Firms

Worker has residual decision rightsFirm has residual decision rights

Usually efficient risk-bearing, firm pays fixed wage

Examples:

Restaurant chefpersonal chef

(chef decides on menu)(client can decide on menu)

Balinese conciergepersonal valet

Freelance journalistStaff writer

Spot market fruit pickerEmployee

Outside legal counselInside legal counsel

Management consultantInternal planning staff

New York cab driver (owns)LA cab driver (rents from owner)

Make or buy decisions

Buy herbs from spot marketOwn herb gardens

("upstream integration")

Contract w/ movie theater to show moviesOwn movie theater ("downstream" integration")

Franchise (sell rights to franchisee for Company-owned store

fixed fee plus %)

BEM 146, Prof Camerer (10/07/02)

Chs 9-10 BSZ: Game theory & incentive conflicts

Basics of game theory:

Players, strategies, information, moves, outcomes, utilities

Key ideas: Dominated strategies (yield (weakly) less than dominant strategies).

Denote player I's strategy choice by s_I

Strategy s_d is dominated for player I if

I.e., u_i(s_1, s_2,…s_d, …s_n)<=u_I(s_1, s_2,…s_i*, …s_n)

for all (s_1,s_2,..s_n) and for (at least) one s_I*.

Nash equilibrium u_i(s_1*, s_2*,…s_i*, …s_n*)>=u_i(s_1*, s_2*,…s_i, …s_n*)

For all s_i

(a mutually consistent point where A's beliefs match B's optimal choice and vice versa)

Mixed strategy equilibrium: Probabilistic mixtures of strategies are the only "mixed" strategies that form a (weak) equilibrium.

Examples:

"whale hunt" whale pig

whale2,20,1

pig1,01,1

"battle of the sexes"Pat

"Under Tuscan Sun" "Beyond Reanimator"

UTS2,10,0

Chris BR0,01,2

Prisoners' dilemmaCD

C2,20,3

D3,01,1

Hotelling location games:

N firms locate on a line [0,1] irreversibly, in order.

Customers evenly distributed.

Customers go to the nearest store.

Where do customer-maximizing firms locate?

N=2 case. N=3 case.

Betting games:
1 and 2 are each privately informed about a "set of states"

1 will know "It's A or B" (A B) or "It's C or D".

2 will know "It's A" or "It's B or C" or "It's D".

ABCD

1's payoffs+32-28+20-16

2's payoffs-32+28-20+16

e.g. A="earnings will be great"

B= "earnings will be good"

C= "earnings will be bad"

D="earnings will be terrible"

1 knows whether earnings will be (good or great) or (bad or terrible)

2 knows whether earnings will be surprising-- either great, (good or bad), or terrible.

When should you bet?

Precontractual information problems (hidden information or adverse selection)

Africa: Rice bags sold by weight. Often filled with (hidden) stones to raise their weight.

LA: The world capital of "used cardboard". Why? Cardboard sold by weight.

It is never soaked by rain (which distorts the weight) because it rarely rains in LA!

E.g. insurance. Who's a good risk? Riskiest people will buy more insurance-- the firm faces "self-selection" which is "adverse".

(Solutions: Deductibles; experience rating (car insurance goes up after accidents); group coverage; health checkups).

"Lemons" problem.

A firm is worth v to seller, uniform [0,100]

It's worth 1.5v to buyer. How much should buyer pay to maximize expected gain?

Postcontractual information problems (hidden actions or moral hazard)

E.g. "shirking" (e.g. cops "cooping"). Overbilling.

Amazing example: Air traffic controller "system errors".

System Error is when two planes come w/in 3 horizontal miles or 1000 vertical ft.

Number of errors (reported by controllers) shot up after 1972, after psychiatrists were allowed to certify medical disability & law provided "2nd Job" training to "disabled" controllers.

"Holdup problems".

One party A makes a large relationship-specific investment with B

that makes it costly to switch to a new trading partner.

B then demands more, exploiting A's inability to switch.

Examples: Suppliers locating plants near customers.

Marriage?? (men typically gain weight after getting married)

Printing presses-- they are rented by magazines, owned by newspapers. (Why?)

How to limit moral hazard?

Monitoring (e.g. "spying" on retail employees, tracking truckers with GPS).

Reputational incentives

Word of mouth

EBay "testimonials" from satisfied buyers

Lawsuits (e.g., class actions)

Escrow

"Bonding" or collateral (e.g., maid services are bonded)

long-lived institutions (e.g., family names, Krazy Karl's Karpet Barn, political parties)

Stock market value after airplane crashes, product recalls etc.

But…markets may under/overreact (e.g., all Arthur Anderson employees get tainted)

Bad workers can get good recommendations to "outplace" (academic hiring-- phone vs letter)

"Capital T" endgame/lame duck problem (e.g., President Clinton final-hour pardons)

Agency relations: An agent makes decisions on behalf of a principal

agentprincipal

CEOstockholder

Presidentvoter

Personal rep. Actor

Parentchild

Teacherstudent

Public employeetaxpayer

An agency cost is

(i)the difference between what a principal would like the principal to do and what the agent does

(ii)the cost of writing and enforcing a contract to limit (i)

Common categories of agency costs for corporate managers:

• "effort"-- any productive activity managers don't want to do at the margin

long hours

short hours! (workaholics should work less?)

nepotism

skiing! (Atomic Ski CEO said going to skiing tournaments is effort)

?

• Perks (perquisites; anything that doesn't add to profits)

"empire building", giving to friends' charity, fancy offices, etc.

private jets

forgiveable loans

• Differential risk exposure

Managers don't want to hold too much company stock; take too little risk

(options go overboard?)

• Differential time horizons

Managers only plan to stay a few years; stockholders care about the long run

(studies show more pay-for-performance for older mgrs with fewer years to go)

• Overinvestment

Mergers & acquisition (M&A), new headquarters, spending cash

BEM 146, Prof Camerer (10/14/02)

Chs 11-13 Notes

Ch 11: Organizational architecture

Three "legs of a stool"

• Decision rights (who decides)
• Rewards
• Performance evaluation

Bad balance:

E.g., An airport mgr who has decision rights over allocation of labor refused to send a mechanic to fix a grounded airplane to save $100 (comes from his budget). Decision right should be allocated to a person who cares more about overall efficiency. (BSZ p 272)

Corporate culture:

How business is (really) done.

"Implicit contract"

Often conveyed by rituals, symbols, heroes/villains (Mary Kay, Disney), slang, slogans ("Quality is job 1"; "Just do it"), stories

Can enhance efficiency by coordinating action (people know what to do), signaling to prospective employees what the firm values.

When architecture fails

• Benchmarking. (Compare to "best practices" elsewhere; rose after US firms scared by global competition.)

• Firing ("termination") (for CEOs, rare—1.5%/yr, awkward, costly)
• Market for corporate control (proxy fights, takeovers, "active shareholders" e.g. CALPERS-- major influence on "good governance")
• Competition (economic Darwinism). (Depends on variation, how free competition is, quality of customer "policing"-- Blockbuster vs. Chinese food in Monterey Park).

Ch 12: Decision rights & empowerment

Key feature:

Degree of centralization.

E.g. JC Penney local buyers watch TV displays from New York.

Benefits of more decentralizationcosts

Use local knowledge (tastes, prices)poor info. Sharing (Haagen-Dazs)

Saves corporate staffcoordination failure

Motivates local managers (empowerment)incentive problems? (too much local risk)

(trains, provides info for later promotion)

Example: Honda. 1948-73 run by Soichiro Honda.

1973-91 "consensus" in waigaya (noisy-loud) meetings

1991-return to more centralization with "car czar" divisions

Teams

Recent trend: Teams as decision making units. E.g. Monsanto "box buddies".

"Extreme programming"

• Benefits:

division of labor (team members specialize),

"buy-in" (people accept a decision that is "procedurally just")

• Costs:

Coordination & slow speed

Free-rider problem (bicycle riding experiments)

Optimal team size? (2 to 25).

(Wild idea: Team management works if team is "family size")

Details of decision rights:

Decision managementControl

Initiation (what to do?)

Ratification (yes/no approval)

Implementation (do it)

Monitoring/evaluation (did it get done well?)

Separation reduces incentive problems.

E.g., house buyer/architect, programmer/client.

Constant iteration for approval of changes etc.

E.g., car mechanics/physicians. Monitoring often done by the repairperson. Bad.

Fix? Second opinions, litigation, etc.

Separation also creates influence costs:

Lobbying for ratification of decisions which benefits the lobbyist.

Policies are often designed to limit influence activities.

E.g. seniority rules for promotion (airline flight selection), require outside job offers for raises…

Ch 13: Jobs & bundling

What's a job?

A bundle of tasks.

Bundle to create diversification (salesman w/ multiple products), complementarities (teaching & research), flexibility, keep worker busy (projectionist/popcorn seller), exploit specialization (geographical regions for sales)

E.g. how are tasks bundled in restaurant work?

Tasks: Supply of capital

Reservations

Seating

Order taking

Cooking

Purchasing

Menu design and pricing

Prep

"line cook"

desserts

Order delivery

Coffee service

Table bussing

Settling check

What's bundled with what?

Interesting exception: Dim sum. Why is it different?

Divisional organization ("M-form"):

Geographical (e.g., multinationals)

Product lines (e.g., car companies)

Research specialties (Caltech 6 academic divisions)

Hallmark greeting card "holiday teams" (matrix organization)

Emergency room: "Teams" assemble & dissolve around patients (cases)

GTE (BSZ p 329) telephone "case workers"

Versus

Honor versus Monitoring

Galen Loram (0803)

According to Rutgers University Professor Donald McCabe with the Center for Academic Integrity, the recognized expert on the topic, 75% of college students admit to cheating at some point during their college years. At Caltech students, faculty and staff postulate only 2-4% cheat. What is responsible for the 20-fold discrepancy?

Virtually all corporation older than a month or two have some sort of corporate culture. What about academic institutions? Most do – they range from the emphasis on sports at the University of North Carolina to the pledge not to drink, have sex or even dance that students at WheatonCollege in Illinois make to the cherished liberalism and activism at the University of California in Berkeley. The California Institute of Technology, a small university in Southern California with a focus on math and science has at the core of its culture an honor code. This code simply states: “No member of the Caltech community shall take unfair advantage of any other member of the Caltech community.” The honor system has far reaching implications – students and professors both leave their doors open and unlocked frequently, exams are take-home and sometimes closed book and it is tacitly assumed that people will read, understand and follow collaboration policies in classes – or clarify misunderstandings.

Many schools have some sort of honor code but most are taken lightly - sometimes to the point of students not knowing about their existence. So what differentiates an effective honor code from one that hardly makes it into the guide for incoming freshman? A recent study by the Center for Academic Integrity found that 82% of its members – colleges nationwide – felt that if a school did not have an effective honor code now it was either ‘very difficult’ or ‘not possible’ to create one. This suggests a strong founder effect: when the university was founded tens or hundreds of years ago, what the founders decided to implement in the way of an honor code has a marked impact on the community years later. Cultures do not arise overnight, and one which requires a vast amount of trust on the part of all concerned and rests on peer enforcement is fragile at best; thus while in the process of attempting to create such a culture a few ‘bad apples’ could ruin the barrel.

One of the fundamental premises of the Caltech honor code is peer enforcement. If one student sees an honor system violation it is his or her responsibility to report it. Failing to report an honor system violation is, in and of itself, an honor system violation. This meta-norm necessitates a culture where new members of the community are indoctrinated into the system under the assumption that the code works. Perception is incredibly important: if students, faculty or staff do not believe that the code is followed – whether or not it actually is - they will not feel obligated to follow it themselves. Thus a strong sense of community is necessary to maintain the code.