EMO Concept List
Organizations arise when markets and contracts are imperfect:
- Hidden actions, moral hazard and imperfect performance measures
- Hidden characteristics, adverse selection, signaling and screening
(Some) organizational responses to these problems:
- Adjusting (monetary and non-monetary) incentives
- Relational contracts (repeated interactions & reputation)
- Allocation of ownership / decision rights
- Rule-based / inflexible decision-making (commitment)
- Obscuring information flows
- Organisational structure and job design
(Benchmarks) Markets and organisations deliver maximum efficiency in case of: perfect competition
and perfect contracts.
First-best efficient: refers to the optimal allocation of resources in a market where all information is
available, and no externalities or transaction costs exist. In this scenario, resources are allocated in
such a way that no one can be made better off without making someone else worse off (Pareto
efficiency in perfect competitive markets).
- Organisations only arise when the market fails, so they can never be first-best efficient. Often
when transaction complexity increases.
- The first-best outcome maximises efficiency / surplus.
- Market failure: occurs due to market power imbalances, externalities in production/
consumption and asymmetric information → imperfect competition
- Second-best: given that there is a particular problem, the solution is as good as it gets. It is
not perfectly efficient as in case of first-best, but there is no better outcome
Coase theorem (perfect contracts): when the parties affected by externalities can negotiate
costlessly with each other, an (pareto) efficient outcome results no matter how the law assigns
responsibility for damages (contract).
- Then, coordination achieved through efficient bargaining, and motivation through contract
enforcement.
Asymmetric information: parties differ in their information about (aspects of) the transaction.
- Principal-agent problem (model): assumption that the principal and the agent do not
automatically have aligned preferences.
- Moral hazard → Agents may make choices that are not (fully) in the interest of the
principal
- Adverse selection → agent does not automatically have an incentive to honestly share
the information with the principal
1
, Tutorial 1 and Lectures 2 and 3: Incentives and multi-tasking (hidden actions)
Hidden actions → Principal-agent problem → Moral hazard → Lower efficiency
Hidden actions: non-verifiable actions (fx effort level) that affect the value of a transaction.
- Non-verifiable actions are actions that cannot be enforced by contracts. The payment to actor
2 cannot be made dependent on the choice of actor 1.
Moral Hazard: lower efficiency of transactions
- In case of hidden actions, agents will choose an action that maximises own utility, rather than
maximise efficiency.
- Can be avoided through :
- Monitoring (costly)
- Back-loading payments (problem: reversed moral-hazard problem)
- Pay for performance (problem: measuring performance)
- Recruiting motivated employees
- Indoctrination/investing in loyalty
Multitasking: actors do not allocate their time and effort appropriately across tasks. Arises when the
actor is disproportionally rewarded for (performance in ) some tasks.
- key insight: you get what you pay for: if some aspects of one's performance are hard to
measure, rewarding other aspects of performance may make non-measurable ones ignored →
reduces the value of the transaction.
- Arises in case of non-congruent performance measures
Private vs Public Ambulance Services
- Private companies have the incentive to work efficiently at lower costs (have high-powered
incentives when components are verifiable), but this has an adverse effect of reducing quality
especially when measuring non-verifiable actions (in this case through mortality rates)
- Staffing differences, such as training and work-hours, between public and private companies
result in higher mortality rates among private companies.
- Private companies tend to leave patients at home more often, this is a multitasking problem
because they only focus on verifiable tasks, and therefore can lead to bad performance in
non-verifiable tasks → e.g. higher mortality rates as a result.
Rent-seeking vs productive activities
Rent seeking is defined as any practice in which an entity aims to increase its wealth without making
any contribution to the wealth or benefit of society. Asset ownership and performance pay are seen as
a means to motivate hard work.
- Disadvantage: Stimulating unproductive activities → distorted performance pay incentivises
workers to game the system meaning that a principal agent problem might appear.
- Implies a tradeoff between productive and rent-seeking incentives → multitasking problem as
the agent aims to maximize their own utility.
Non-standard preferences: non-monetary benefits to working.
- The utility function is extended with intrinsic motivation, joy etc. The size of the parameters
depend on the match between the firm and the employee.
2
Organizations arise when markets and contracts are imperfect:
- Hidden actions, moral hazard and imperfect performance measures
- Hidden characteristics, adverse selection, signaling and screening
(Some) organizational responses to these problems:
- Adjusting (monetary and non-monetary) incentives
- Relational contracts (repeated interactions & reputation)
- Allocation of ownership / decision rights
- Rule-based / inflexible decision-making (commitment)
- Obscuring information flows
- Organisational structure and job design
(Benchmarks) Markets and organisations deliver maximum efficiency in case of: perfect competition
and perfect contracts.
First-best efficient: refers to the optimal allocation of resources in a market where all information is
available, and no externalities or transaction costs exist. In this scenario, resources are allocated in
such a way that no one can be made better off without making someone else worse off (Pareto
efficiency in perfect competitive markets).
- Organisations only arise when the market fails, so they can never be first-best efficient. Often
when transaction complexity increases.
- The first-best outcome maximises efficiency / surplus.
- Market failure: occurs due to market power imbalances, externalities in production/
consumption and asymmetric information → imperfect competition
- Second-best: given that there is a particular problem, the solution is as good as it gets. It is
not perfectly efficient as in case of first-best, but there is no better outcome
Coase theorem (perfect contracts): when the parties affected by externalities can negotiate
costlessly with each other, an (pareto) efficient outcome results no matter how the law assigns
responsibility for damages (contract).
- Then, coordination achieved through efficient bargaining, and motivation through contract
enforcement.
Asymmetric information: parties differ in their information about (aspects of) the transaction.
- Principal-agent problem (model): assumption that the principal and the agent do not
automatically have aligned preferences.
- Moral hazard → Agents may make choices that are not (fully) in the interest of the
principal
- Adverse selection → agent does not automatically have an incentive to honestly share
the information with the principal
1
, Tutorial 1 and Lectures 2 and 3: Incentives and multi-tasking (hidden actions)
Hidden actions → Principal-agent problem → Moral hazard → Lower efficiency
Hidden actions: non-verifiable actions (fx effort level) that affect the value of a transaction.
- Non-verifiable actions are actions that cannot be enforced by contracts. The payment to actor
2 cannot be made dependent on the choice of actor 1.
Moral Hazard: lower efficiency of transactions
- In case of hidden actions, agents will choose an action that maximises own utility, rather than
maximise efficiency.
- Can be avoided through :
- Monitoring (costly)
- Back-loading payments (problem: reversed moral-hazard problem)
- Pay for performance (problem: measuring performance)
- Recruiting motivated employees
- Indoctrination/investing in loyalty
Multitasking: actors do not allocate their time and effort appropriately across tasks. Arises when the
actor is disproportionally rewarded for (performance in ) some tasks.
- key insight: you get what you pay for: if some aspects of one's performance are hard to
measure, rewarding other aspects of performance may make non-measurable ones ignored →
reduces the value of the transaction.
- Arises in case of non-congruent performance measures
Private vs Public Ambulance Services
- Private companies have the incentive to work efficiently at lower costs (have high-powered
incentives when components are verifiable), but this has an adverse effect of reducing quality
especially when measuring non-verifiable actions (in this case through mortality rates)
- Staffing differences, such as training and work-hours, between public and private companies
result in higher mortality rates among private companies.
- Private companies tend to leave patients at home more often, this is a multitasking problem
because they only focus on verifiable tasks, and therefore can lead to bad performance in
non-verifiable tasks → e.g. higher mortality rates as a result.
Rent-seeking vs productive activities
Rent seeking is defined as any practice in which an entity aims to increase its wealth without making
any contribution to the wealth or benefit of society. Asset ownership and performance pay are seen as
a means to motivate hard work.
- Disadvantage: Stimulating unproductive activities → distorted performance pay incentivises
workers to game the system meaning that a principal agent problem might appear.
- Implies a tradeoff between productive and rent-seeking incentives → multitasking problem as
the agent aims to maximize their own utility.
Non-standard preferences: non-monetary benefits to working.
- The utility function is extended with intrinsic motivation, joy etc. The size of the parameters
depend on the match between the firm and the employee.
2
