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 (-$1.5 billion). Why? Suppose to be doing arbitrage (buy low/sell high simultaneously in Osaka/Singapore; so common movements cancel out) Actually "plunging" on stocks, buying "naked"/unhedged (without selling) How did he get away with it? Poor architecture: Most firms, traders have decision right on what to trade Back office workers have decision right on overseeing paperwork Traders rewarded bonuses for performance (numerical evaluation) incentive to take huge bets; if they lose, don't have to pay Ch2 Marginal analysis (water vs diamonds, work vs. play) Opportunity cost (e.g., NBA underachievers study) Utility, constraints Theories of worker motivation: Money (not everything...but does not "satiate" and most uniform across people) (why important? Often misunderstood-- parking, tax incidence, journal$) 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. ) 1 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

2 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 deaths 8.0% 6.2% # of ships (# lost) 1.63 (.53) 1.15 (.24) scurvy 46.7% 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:

3 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 rights Firm has residual decision rights Usually efficient risk-bearing, firm pays fixed wage Examples: Restaurant chef personal chef (chef decides on menu) (client can decide on menu) Balinese concierge personal valet Freelance journalist Staff writer Spot market fruit picker Employee Outside legal counsel Inside legal counsel Management consultant Internal planning staff New York cab driver (owns) LA cab driver (rents from owner)

Make or buy decisions Buy herbs from spot market Own herb gardens ("upstream integration") Contract w/ movie theater to show movies Own movie theater ("downstream" integration") Franchise (sell rights to franchisee for Company-owned store fixed fee plus %)

4 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 whale 2,2 0,1 pig 1,0 1,1

"battle of the sexes" Pat "Under Tuscan Sun" "Beyond Reanimator" UTS 2,1 0,0 Chris BR 0,0 1,2

Prisoners' dilemma C D C 2,2 0,3 D 3,0 1,1

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". A B C D 5 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).

6 "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

agent principal CEO stockholder President voter Personal rep. Actor Parent child Teacher student Public employee taxpayer

7 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

8 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 decentralization costs Use local knowledge (tastes, prices) poor info. Sharing (Haagen-Dazs) Saves corporate staff coordination failure Motivates local managers (empowerment) incentive problems? (too much local risk) (trains, provides info for later promotion) 9 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

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 management Control 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.

10 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"

11 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 Wheaton College 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. 12 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.

While the benefits of the honor code come in a variety of forms, one of the most important is reduced monitoring costs. Unproctored exams liberate professors to focus on their research instead of wasting time futility looking for cheaters. Conversely, students benefit from the chance to take exams in a situation of their own choosing – blasting Nine Inch Nails on their stereo, sitting next to a tranquil stream, or sitting a desk in the classroom where they learned the material. Another benefit comes in the form of gift exchange. Students feel that they are trusted and thus feel obliged to return the favor in the form of not cheating. Graduate TAs are freed from deeply probing for similarities, instead only looking at something if it catches their eye: the vast majority of the honor system violations are incredibly blatant and occur when someone is under extreme stress (perhaps a close family member is diagnosed with terminal cancer or some similar tragedy occurs) and ‘cracks.’ The other main source of violations is ignorance. For example, a student from a foreign country may not understand the idea of plagiarism and might submit a paper that heavily relied on a couple of sources and failed to cite them. The increased atmosphere of trust also allows for other benefits, people can accidentally leave their bag around campus with hundreds of dollars inside and come back hours later to find it still sitting there unperturbed. The unspoken threat of social ostracization of a cheater tends to be enough to keep those who would still consider cheating in line.

There are drawbacks too, of course. Doubtless, without the close scrutiny a higher percentage of those who do cheat manage to ‘slip through the cracks’ and not get caught. For those 15-20 cases of suspecting cheating each year that do get reported the chair and secretary determine whether or not the issue at hand is an honor code issue, and whether enough evidence is present to warrant the attention of the Board of Control. Examples of something that would not warrant the attention of the Board would be someone being rude to someone else or a case of suspected copying when the two exams had nothing in common. The Board of Control (BoC) – then views the evidence, interviews any potential defendants and witnesses and then makes three decisions – whether or not an honor system violation has occurred, how to nullify any unfair advantage gained, and how to protect the community from such a thing happening again. These are recommendations to the deans of students and are accepted about 95% of the time. Because there are so few cases each case is treated meticulously – a very time consuming process. An average case of cheating or “overcollaboration” that goes to the BoC takes about 60 man-hours.

13 Chs 14-15: Hiring and pay: Labor market and principal-agent models

Pay: Competitive model-  All workers & firms the same (e.g. migrant farm worker picking)  Marginal revenue product of a worker (MRP) is easily measured  Market wage=MRP (if too low workers bid down by competing; if too high firms lose money and go bankrupt)

Sidebar: Piece rates. See below—Safelite (auto glass installation) introduced piece rates. Productivity of current workers clearly went up. There was some also sorting (i.e. people who left were those who had been less motivated, people who stayed were more motivated) and there is a learning effect (piece rates took time to sink in). Incentive boomerang: Did quality suffer? Perhaps...(poorly installed glass, too fast). What to do? First system: Track who installed, assign the reinstallation to the installer’s workgroup (hope that peer pressure would motivate workers to do a good job). Not ideal. Switched to a system in which the “guilty” sloppy installer has to redo the installation (firm pays for cost of new glass).

Safelite Glass Corporation

Safelite Glass Corporation is the largest installer of automobile glass in the U.S. During 1994 and 1995, glass installers were shifted from an hourly wage schedule to a piece rate schedule. On average installers were paid about $20 per unit installed. At the time that the piece rates were instituted, the workers were also given a guarantee of approximately $11 per hour. If their weekly pay came out to be less than the guarantee, they would be paid the guaranteed amount.

The new system was instituted because management believed that productivity was below what it should have been. Productivity could have been raised by requiring a higher minimum level of output under a time-rate system, coupled with a wage increase. However, since workers have different preferences, such a change might not be acceptable to all workers and might induce massive turnover. The firm therefore adopted a piece rate system, which allowed those who wanted to work more to earn more, but also allowed those who would accept lower pay to put forth less effort.

The output measured used is units-per-worker-per-day. Upon the change from time-rate to piece-rate,

14  average output increased from 2.70 to 3.24  the standard deviation of output increased from 1.42 to 1.59

The following table shows more detailed regression results for log output:

(1) (2) (3) (4) (5) ______PPP dummy 0.368 0.197 0.313 0.202 0.309 tenure 0.343 0.224 0.424 time since PPP 0.107 0.273 0.130 new regime 0.243 worker fixed effect no yes no yes no time fixed effect yes yes yes yes yes

 Other things also change during the switch to piece rate. When time effects are added to account for these other things, the coefficient for PPP (pay- for-performance) is 0.368, which corresponds to approximately a 44 percent gain in productivity.  The composition of workers have changed over time. When individual worker effects are added to the regression, the coefficient for PPP is still positive (0.197) and significant. It implies a 22 percent increase in productivity. This is a pure incentive effect.  The difference between 0.368 and 0.197 can be interpreted as a sorting effect. PPP offers greater incentive to existing workers and also attract more able workers to join the firm. [That is, controlling for differences in individual worker productivity, there is still an effect of the PPP, that is the .197 effect, but the fact that .368>.197 means some of the effect was “sorting”]  The coefficients on "tenure" in equations (3) and (4) indicate that there is significant learning on the job. [Note this is a huge effect! As large in magnitude as introducing PPP in the first place—this indicates that experience is a kind of substitute for incentive].  The coefficients on "time since PPP" indicate that the incentive effect of PPP grows over time. In equation (4), for example, the initial effect of switching from hourly wage to piece rate is to increase log productivity by 0.202. After one year on the program, the increase in log productivity has grown to 0.475. If the Hawthorne effect [i.e. simply changing incentives has a temporary response which wears off] held, then the longer the worker were on the program the smaller would be the effect of piece rates on productivity.  The "new regime" variable is set to 1 if the individual worker was hired after January 1, 1995, by which point almost the entire firm had switched to piece work. Equation (5) shows that workers hired under the new 15 regime have log productivity that is 0.24 greater than those hired under the old regime, holding tenure constant.

The worker fixed effects estimated from the regressions above are indicators of worker ability. Lazear finds that the median level of fixed effect for those who leave no later than two months after the start of the piece rate system (the leavers) is 0.15. The median level of fixed effect for those who stay beyond the initial two months (the stayers) is 0.22.

The log of pay-per-worker went up by 0.099, implying a 10.6 percent increase in compensation following the introduction of pay for performance. This is under half the increase in per-worker productivity. 92 percent of workers experienced a pay increase.

Piecework requires measurement of output. In Safelite's case, the measurement comes about through a sophisticated information system. This system was initially put in place for reasons having to do with inventory control and reduced installation lags. The economies of scope in information technology, coupled with the labor productivity gains, are probably large enough to cover whatever additional cost of monitoring was involved.

One defect of paying piece rates is that quality may suffer. In the Safelite case, most quality problems show up rather quickly in the form of broken windshields. Since the guilty worker can be easily identified, there is one easy solution: the installer is required to reinstall the windshield on his own time and must pay the company for replacement glass. Safelite tried to rely on peer pressure initially, assigning the replacement job randomly to a worker in the same workgroup. Subsequently, the system was changed to assign re-do work to the worker who was responsible. Workers are not charged the replacement cost of glass. Customer satisfaction went up after the introduction of PPP.

Six realistic complications to wages=MRP model: 1. human capital (different workers are differentially productive due to knowhow or “human capital”); 2. compensating differentials (holding productivity and capital constant, some people like different kinds of “unpleasant” work—risky, lonely, etc.). 3. discrimination (workers of different types are treated differently due to ethnicity, gender, religion...). Is it statistical? (I.e. demographics are proxies for hard-to- 16 observe differences in quality) Tastes of employers (e.g. Italians don’t like hiring African-Americans)? 4. Upward sloping wage profiles (even as productivity peaks, often say at age 50, wages tend to go up especially for “career tracks” or when enforced by unionization) 5. Wage compression (workers at similar ages earn wages which are compressed relative to measurable productivity) 6. Internal labor markets (explanation for 4 and 5).

1. Human capital: Suppose you run a "wage equation in which you relate wages for a worker I at time t (left hand side) to various observables you think should be correlated with MRP (age, education, measured productivity, etc.). There are effects of variables which create wage differences. Major examples: Human capital (creates higher MRP and hence higher wage); compensating differentials (work is pleasant or unpleasant given skill requirements); possibly discrimination.

17 above: A “Mincerian” (after Jacob Mincer) wage equation which regresses log wages against various factors (from Radchenko and Yun, 02, data from 2000 Current Population Survey on 5000+men). Coefficients are approximately percentage increases in wages for various categories. For example a year of education increases earnings by 5%; for whites living in a city (MSA) increases earnings by 10%

Human capital: Specific knowhow which commands a wage premium

18 (n.b. originally defined by Becker as a "residual" in a wage equation-- something the firm is paying extra for that is not picked up by the other wage-equation coefficients) general human capital (commands a wage premium at all firms; you can leave one firm and attain the same earnings using these skills at another firm) specific human capital (commands an extra wage premium at some firm(s))

General: Language Computer skills Problem solving skill Smiling/friendliness (cruise director, airline attendant) Meanness (debt-collections agent)

Firm-specific: Knowing “local culture” Knowing personalities

(Question: Is there really much firm-specific capital??)

Note: Much capital is probably industry-specific, in between general and firm-specific. E.g. knowing industry jargon...

Below: estimates of returns to education (staying one extra year in school, in terms of percentage increase in wages) in European countries. Note very high return to women (red bars) relative to men in the high-end (right hand) countries. The low return in Scandinavian countries is probably because they are highly socialized so even uneducated workers are paid well (almost like a country-wide union).

19 Hamermesh and Biddle (above): Mild beauty premium in wages; strong unattractiveness penalty (*especially* for men, around 10%). Below: effect is *not* solely due to say weight or height (only separate effect is a short-man penalty, 10%).

20 above from Dan Hamermesh paper (UT Austin, 1-5 scale, interrater correlation of beauty ratings is .62). Bigger effect for handsome men (.38/std dev) than beautiful women (.13).

21 2. Compensating differentials Any extra pay (or reduction in pay) for special qualities of work ("psychic income").  Safety (Note that if "daring" workers are paid for risks, they dislike safety reduction)  Thaler-Rosen study on "value of a life" imputed from wage differentials. Note: may be hard to think that we can put a price on a life (or loss of body part) but the fact that people take risks to earn more money (e.g. driving a little recklessly to get somewhere on time) implies they are *revealing* an *implicit* value-of-a-life (note well, that doesn’t mean the values that are revealed are at all consistent across domains, or consistent with stated values). This is common in insurance E.g. where companies are forced to deal with large numbers of cases and without attaching some kind of number or adjustment they cannot do business. E.g. the Caltech benefits handbook (2003) describes what percent of disability benefits are paid for various “loss[es] and illness[es]” (see below). Note that they basically equate a thumb and index finger to be “half a hand” (lose of a hand is 50% payment of full benefit), and “half a foot” and also “half an eye”. So there is an implicit comparison here between thumb and eye.

 NYC taxi drivers earn more driving at night  People work for free at radio/TV internships (fun)  "Combat pay" for very hazardous jobs (putting out oil fires, neurosurgery, teaching MBA’s)  Jobs w/ extra psychic income—e.g. lifeguards. Difficult (e.g. CFC worked in Md resort summer, many lifeguards trying out—physically strenuous, e.g. swim 1 mile thru the ocean—hard!!!). But lifeguarding is fun for guys since one gets female attention.

 Note: Comp differentials may differ greatly across people. This raises an important problem of “assortative matching”—how does the firm get the people who enjoy certain kinds of work (i.e have the lowest compensating differential) in the right jobs? The idea is to minimize the firm’s “wage bill” (total compensation paid out) by choosing workers who will work for the least because they enjoy the work.

3. Discrimination

22 Discrimination: Observable demographic variables (race, gender, age) are often correlated with wages. Is it skill, compensating differentials or what?

Three theories: a. Tastes: Employers have “tastes” for discrimination (or pass on tastes of customers); statistical discrimination (race etc used as proxy for unobservable variables which affect productivity); or “equilibrium traps” (workers of type X believe that they will not get jobs of type Y so they don’t acquire qualifications. Employers would hire type X’s to do Y if they acquired qualifications but there are few examples. Everyone loves this theory because it pins the blame on a mismatch of worker beliefs and employer beliefs—i.e., employers aren’t really discriminating, but workers believe they will and do not create investments which break” the equilibrium; also this theory is handy because it suggests a ready solution—force hiring of type X’s thru affirmative action or subsidies, then X’s will realize they could get a job of type Y and will invest...)

Employer tastes? ( predicts successful discrim’d employees should be *better* on average; e.g. black and white NFL head coaches. Since 1986 black coaches have made playoffs 67% of the time vs white coaches 29%; black coaches average 1.1 more victories per year-- blacks have to do better to overcome discrimination (Janice Madden study LA Times 10/05/02D5).

Related, but fundamentally different: Employers pass on customer tastes. E.g., in Philadelphia restaurant “audit study” of high-end restaurants (e.g. Palm steakhouse) actors with identical resumes interviewed for jobs...employers chose men more than women, claiming that customers prefer male waiters. Employers might not care about gender of waitstaff, but cater to customer tastes. b. “Statistical discrimination”—race/gender/etc a proxy for unobservable components of skill (NYC cab drivers and black passengers). c. “Equilibrium traps” (Arrow/Spence/Coates-Laury). Suppose there is an observable trait (skin color, accent, clothing style) which is uncorrelated with "skill" (i.e., cost of learning a skill). Firms hire based on observables, then "test" for skill. Those who pass the test get good jobs (or get hired at all). Result: You can have a trap in which workers of one type do not invest because they won't get jobs. When they do get jobs, firms "prejudices" are confirmed because workers tend to fail the test. Model of racial/gender/? Discrimination

Resume study (Bertrand and Mullainathan, 03). Send 4890 resumes matched for credentials with black/white names (culled from birth records). E.g. Jamal, Tyrone vs Emily, Chip. Employers call back more whites in all categories, genders (Table 1). Also the call-back premium for high-quality resumes was lower for blacks (consistent with “equilibrium trap” story in which it doesn’t pay for blacks to get educated; see Table 4).

23 24 4. Seniority and pay (upward sloping wage profiles)

Ubiquitous feature of developed labor markets: Workers pay always goes up, regardless of apparent productivity.

Why? (1) Incentivizes workers to invest in firm specific capital (if workers switch pay often goes down a bit). Protects firm investments in general capital (2) Firms "save" money on behalf of workers. I.e. there is an implicit contract in which workers are underpaid when young and overpaid when old. Firm “saves” money on behalf of workers (claim: otherwise people would overspend when they’re young and not have enough when they are older)

5. Wage compression

Wage compression  wages flatter than MRP: Scatter plot of wages (y-axis) and MRP (x-axis) is too flat

E.g. Frank (1984), “Are workers paid their marginal products?”

Example: 18 biochemists and organic chemists (1979-80). Wage compression in salaries (top vs median only $4,642 difference) but huge difference in grant contribution ($152,006) to indirect costs. Why aren’t big grant-getters paid more cash?

E.g. Frank (1984) wage compression even in sales jobs with high commission component. Below: 13 auto dealerships. Stated earnings schedules are a function of gross margin per car times car sales. Most slopes are around .20 (should be one). Also there is persistent cross-year differences in performance: Managers were asked what the most productive salesperson’s *lowest* earnings year was (min_t E*_it) relative to average earnings (Ebar) ;usually the ratio is above 1 so the best seller is *consistently* the best seller. Why isn’t that person paid more?

25 Third piece of evidence—incentives schemes need not have caps, and *shouldn’t* have caps. But half do (see Conference Board 1970 survey figures below from Frank 1984 paper). Why have cap? Presumably because less successful workers resent it. Note—if the point of wage compression is to smooth earnings, what you should have is a cap on the *minimum* (e.g. fixed wage) not a cap on the maximum.

6. Internal labor markets

ILM is a boundary that prevents competitiveness with other firms or workers ("fictional") Very common  Secretarial staff at Caltech  Internal promotion (e.g. army, professional firms, tenure-track…)

26 Why are there ILM's?  Firms capture private information about employee skills  Provides incentives (e.g., tournament theory)  Repeated game relationship supports cooperation/reduces moral hazard

 Efficiency wages: Pay above market wage  unemployment  workers who are fired have a hard time finding work  workers work hard

Gift-exchange: Similar story, workers reciprocate generous wages.

How to distinguish efficiency wages & gift exchange? In eff wage workers should bid away job rents (up front fees, bribes)—very rare In eff wage, wages can be cut in a downturn (rarely so; usually layoffs) In both stories, get “endgame” effects (fact: raise pay for performance for old CEOs)

• Two puzzles: – Why do firms pay “too much” and lay workers off rather than cut wages in downturns? – Why is there involuntary unemployment? • Why don’t workers underbid to get jobs?

Gift exchange/ILM experiments (in class) Workers prepay guaranteed wage w 0-100. Firms exert costly effort e, 1-10 (integer), cost c(e); c(1)=0, c(10)=18 slightly convex. Firms earn 10*e-w. Workers earn w-c(e). Social gain is 10e-c(e); since c'(e)<10 this is maximized at total effort 10. (maximum achievable social gain 100-18=82). Excess supply of workers. Competitive prediction is wage of 1 (don't expect any work) and e=1. Firms earn 10-1=9, workers earn 1-0=1, total is 10 (far short of 82).

Typical result: If firms can earmark offers, establish "internal labor market"/implicit contract with a specific worker. Firms request a particular worker, choose high effort. Workers often turn down higher wage offers from "new firms". Sometimes choose lower e to "ask for a raise" tacitly. Also workers cut out of the market initially (bad luck?) have a hard time getting back in (“stigma of uemployment”)

27 The result is two tiers: High-wage, high effort "good jobs", steady wages, raises; and low-wage, low-effort unskilled bad jobs, turnover (McJobs). These emerge even there are no skill differences per se across workers!

 Why? In the aggregate, results from upward sloping profiles  Consider cross-section, fixing job tenure (e.g. compare all 45-year olds).  Social comparison  Influence costs (underpaid guys complain and waste administrative time)  measurement error (forecasts should be "regressive") --in professions where it is easy to measure (sports, sales, market trading) there appears to be less wage compression

 tastes for status?? (Bob Frank story; people like being paid more than others (dislike being paid less) wage compression

Temporary workers BIG surge in recent years! Costs coordination etc., turnover Benefits flexibility, health insurance etc., can "audition" people

[Note: Adrian Raine, USC, has recruited volunteers for fMRI and other psychological experiments at temporary employment agencies. They find that about 30% are diagnosed with antisocial personality disorder—refuse to follow social rules, violent, neglect their children...!]

Interesting comment (from famous economics blogger Brad DeLong comment on sociology & economics (http://www.j-bradford-delong.net/movable_type/) “It is often debated about how sociology (i.e., social constraints and norms that are independent in the short-run of supply and demand) influences economics and vice versa. Labor markets are a good place in which to observe this interaction.

I have been following the discussion of Karl Polanyi, and I have been worried because it seems to me that of readers are missing the point. I think that Polanyi does have an interesting argument. But it is being hidden from many because of his terminology. The underlying point is that it used to be the case--painting with a very broad brush--that what happened in economic transactions was in large part determined and guided by sociological and political relationships, but that now--again painting with a very broad brush--the principal direction of influence it is reversed: politics and sociology are more shaped by economic factors than they in turn manage to shape what happens in economic transactions.

28 In Polanyi's vocabulary, this is a transformation from an "embedded" to a "market" economy. And many readers do not hear Polanyi's point because their first reaction is: "We have had markets since time out of mind: what was the agora of Periclean Athens?" I'm not sure how true Polanyi's point really is. But I do think it is worth thinking about. What does Polanyi mean by a claim that a market is "embedded" in a society? I think of it this way: In the past two weeks my wife and I have hired three young women--a 22 year old, a 16 year old, and a 12 year old.

The 22 year old is a recent graduate of Berkeley, just back in this Bayarea magalopolis from several months in China, where she was a film producer's assistant. We hired her to give our children swimming lessons (and she occasionally babysits as well). She is a superb swimming teacher and our children adore her. We pay her $40 an hour as a swimming teacher; we pay her $10 an hour as a babysitter.

But we are in the business of paying a fair price for her services as a swim teacher: we were impressed with and grateful to her for the job she did last summer, and so hired her because we feel we owe her for making our children happy and because she is looking for income. So we pay her a fair price--even though we could get a low-overhead private swim teacher for much less--because our relationship has a large element that is probably best seen as a gift exchange.

The 16 year old just moved to Bayarea from Mexico city for her last two years of high school. She and her parents moved up here so that she could get a U.S. education for the last two years of high school; they are living with her sister, who works as an architect in San Francisco. We employ her as an evening babysitter. We pay her $7 an hour as an evening babysitter. We found the 16 year old via reference in conversations at the playground. We pay her $7 an hour--when the market equilibrium rate, to the extent there is a market, is closer to $5.50 an hour--because we want her to value her employment relationship with us and contribute more than just her raw labor power to the job of babysitting our children. You might say that we are in an "efficiency wage" equilibrium. Or you might say that we want to be the kind of parents who pay their babysitters a generous wage.

The 12 year old lives in our neighborhood. She put up a sign at the local playground saying that she was a responsible house watcher, plant waterer, and pet feeder who was eager to earn money. We hired her to watch our house while we went on vacation. Her mother would not let us pay her more than $4 an hour.

The 12 year old is trying to earn money on her own for the first time. The principal determinants of her wage are what her parents will let her accept--they don't want her to believe too soon that getting money from work is incredibly easy. Yet from our perspective the amount we pay her is a very small fraction of the cost to us in hassle and in dollars of finding an alternative person to look in on the house.”

29 Chs 15-16: Incentives (15) and Performance Evaluation (16)

Model of optimal incentives (see MR notes):

Key point-- tradeoff between incentives and risk-sharing  If agents are willing to bear risk, give them all the risk (and incentive) E.g. NYC taxi drivers… "rent" machinery (cab) and keep all fares

Piece rates (clothing manufacture, AAA towtruck drivers, Safelite auto glass) …a bad idea when there is uncontrollable risk (e.g., rainy nights)

Sharecropping-- when yield risk is low, sharecroppers should keep larger %

Individual incentive pay: Piece rates Commissions Bonuses Contest prizes (e.g. vacations) Raises/wage cuts Promotions Titles ("Cheers" story; Woody asks for wage & gets something "better"-- a title) Office assignments etc Stock ownership Stock options (tie employees to the firm) Firings Deferred compensation and unvested pension payments

Group incentive pay: E.g. Continental airlines, $65/month per worker for being in top 5 on on-time arrival Why does it work? (should be subject to free riding) "Peer pressure" -- workers monitor each other. May only take a small number of “cheerleaders” or “busybodies” to make a small group effective. Creates sense of group camraderie & shared goal Encourages cooperation

Basic risk-responsibility incentive model (BSZ ch 15, also Milgrom Roberts ch 7)

Worker “effort” e [unobserved]

Firm observes Z = e + x  measurement error and a variable y which correlates with x, r(y,x) > 0

30 Note that E(x)=E(y)=0 (expected measurement error is zero)

Examples: Share cropping x = bad weather; y = amount of rain x = R&D flop; y = success of others x = lost sales; y = lost sales by others

Pay  w =  + (e+x+ y)

(1) Employee gets  + e – C(e) – ½ r2 var ( x +  y)   “cost” of effort risk premium for bearing measurement error risk ( x +  y) if quadratic utility

(2) Firm gets P (e) -  - (e+x+ y) = P(e)-  - e (E(x)=E(y)=0, firms risk-neutral)  profit

(i) employee optimally chooses e* to max (1)

 = C’(e*) higher   higher e* (assuming C(e) convex so C' increasing)

C(e) Slope 

Effort e e*

(ii) informativeness principle

Total payoff across firm plus employee is (firm) P(e)- - e (worker)  + e – C(e) – ½ r2 var ( x +  y)

To max total payoff, min var (x +  y)= 2(x)+22(y)+2cov(x,y) 

differetiate with respect to , set to 0, gives

  * = -2cov(x,y) = - Cov (x, y)  (x) = - r (x, y)  (x) 31 2(y) (x) (y) (y) (y)

e.g. put a weight on the observable y which goes up if x and y are strongly correlated (e.g., comparative performance [grade curve, “tournament”])

But comparative performance contracts are rare, and usually asymmetric (capped at upper level, or create firing at lower level).

Capped firin perf.for g outperfor- ming x – y 0

(iii) Incentive Intensity Principle

Max (Employee + firm) with  = C’(e) e

2  Maxe P(e) – C(e) – ½ r var ( x +  y) = P(e) – C(e) – ½ r[C’(e)]2 var ( x +  y)

 (.) = P’(e) – C’(e) – ½ r 2C'(e) C’’(e) var ( x +  y) = 0  e =

  = P’(e) / [1 + r C’’(e) var ( x +  y) ]

 need ‘higher-powered incentives”  for: higher P’(e) (bigger return from effort) lower r (less risk-averse employee) lower C’’(e) (less convex C(e) , less increasingly-painful) lower var (.) (less noise in employee’s wage; employee can take risk)

Incentives are a sharp knife

There is no doubt that incentives do affect behavior—sometimes in the long run, and sometimes differentially across people—but incentives do have an effect. In fact, incentives affect behavior *so* well that one must be very, very careful in designing an incentive system. The main point 32 of this course is that the allocation of decision rights (who gets to decide), compensation, and evaluation must all fit together. If evaluation is not designed properly, then increasing incentives to perform some activity may actually hurt. Furthermore, a major problem with incentive design is that people who are performing more of one activity may do less of another (or more of a complementary distortionary activity).

Thus: incentives are a very sharp knife. Handle them wisely. Some “incentives gone wild” examples illustrate how a well-intentioned simple incentive system can backfire, sometimes horribly so. At the same time, avoid the “Nirvana fallacy”: Every incentive system will create distortions and shortfalls from perfection. The issue is not whether the system failed—all do, in some ways—the issue is whether a simple change would remove a large problem and, inevitably, create a smaller one in its wake.

Incentives gone wild, I: • New Orleans: – Murder capital of the US c 1990. – Incentives: Districts that showed improvement in crime statistics got awards that could lead to bonuses and promotions, while districts that didn't faced cutbacks and firings. [NB: Isn’t that backwards?!?]

• Result: Underreporting violent crimes. [An] investigation found that in the last year and a half in that one NO district, 42% of serious crimes were classified as minor offenses and never fully investigated. • Five cops fired. • E.g. Eric Frase (ph) attacked by four people who beat and slashed him in the face. • Patrolman reported an aggravated assault. • 1st District sergeant [near the famous French Quarter] forced him to change it to a miscellaneous incident. • The FBI, which collects the crime reports, doesn't check their accuracy and says there's no penalty for police departments that turn in false reports.

• (NPR, 10/30/03)

Incentives gone wild, II:

Jacob-Levitt QJE (03) paper on teacher cheating. Data from grades 3-8, 1993-2000 in Chicago public schools.

Increased incentives for teachers to cheat on tests. Federal legislation, “No Child Left Behind” (2001) requires schools to test elementary students each year, rate schools, and “fix” schools with poor scores. (Most states have similar plans. E.g. in California c 2000, $25,000 bonus per teacher for schools making the most progress.)

How to catch cheating teachers?

33 a. look for statistically unusual strings of correct answers (standard multinomial comparison) b. look for unusual fluctuations in gains from year to year (e.g. way up one year, down the next). c. look at unusual exogeneous retest experiment

Unusual strings example (next page Fig 1)—letters are correct answers. Numbers are incorrect answers. Next table (Table II): using very conservative cutoffs, how many are cheating? At least 1.1% on any one test, 3.4% on at least one of four tests

34 example 35 Which teachers are likely to cheat? Regress classification of cheating against various indicators. (Table V)

Strong influences: Teachers giving test to their own students (.66%) Getting rid of “social promotion” and “putting schools on probation” (.2%) Accentuated by poor previous performance Younger teachers (<30) Predominantly black schools (.68%)

36 37 Incentives gone wild III: Underreporting school violence (NYTimes 11/06/03, thanks to Lailaini Arci)

“School Violence Data Under a Cloud in Houston” Reporting that schools are way underreporting violence compared to PD statistics....see pic below. Schools are not counting crimes reported to Houston cops. Why not? (Parents, and also teachers—many assaults are students against teachers.)

38 ch16: Executive compensation

Wide public debate: Are CEO's paid too much?

 Interesting scientifically because there are good data on what public CEOs are paid (annual reports, 10K's) and how their firms perform.  Sharp test of agency theory principles  Important for economic efficiency, public policy (is inequality bad?)

1: How much are they paid?

Answer: A lot!!!!! Relative to MRP? Who knows. How to measure MRP of a CEO? It could be very, very high; but hard to measure without having an ABA design experiment (CEO takes a long vacation and comes back). Forbes 2002 (of Fortune 500 CEO’s): Top 20 CEO’s earned total comp from $35-$706 M, median $88 M (mostly exercised shares) Bottom 20 $.084-.785 M

Compared to who/when?

 A. The recent past: Brian Hall (03, Figure 1): Huge increase in (inflation-adjusted) salary & bonus plus equity-based pay (including options).

39 

 B. To regular workers: Can also compare to average manufacturing worker salary W(see Figure 2 above). 1980, average CEO salary and bonus around 30 times W. Huge runup in total pay (including options & stock) 1990-2003. Multiple of average worker pay now around 350!!!

[Why? Social comparison? One hint (see Hall-Murphy 03 JEcPers)t: 1993 rules changes in US required companies to disclose more details of how top execs are paid in proxy statements (10-K filings)—the hope was that it would stem the rise in pay packages. But this told CEO’s how much others were getting. Since many boards use these “pay surveys” to set pay, and everyone thinks their CEO is above average, it led to a spiral in which everyone earned more and more and more. Requiring more disclosure was really adding fuel to the fire rather than dousing it. E.g. imagine if Caltech professor salaries were publicly disclosed? There would be a tremendous amount of lobbying from underpaid professors which would lead to catch-up increase, which might lead to increases among those at the top who think they deserve more...]

40  C. To other countries (old numbers): Japan 17 times worker earnings France/Germany 24 worker earnings (Japan & Europe CEOs get more perks than US-- housing, private clubs etc.)

Multiple choice: You MUST choose one a. 2003 CEO’s are 20 times more productive (relative to workers) than 1980 CEO’s b. 2003 CEO’s are overpaid c. 1980 CEO’s were underpaid

Multiple choice, part II: From an economic (equilibrium) point of view you MUST choose one: a. Japan/Europe CEO’s aren’t as valuable or talented as US (lower MRP) b. US are overpaid c. Japan/Europe underpaid

Which is it? (I vote for b).

Trend in share of equity-based pay and “at-risk” pay (bonus plus equity-based) is catching up in other regions. (Brian Hall Table 1) however. Europe/Asia/Latin America/UK roughly 5 years behind.

D. Other industries with "superstar effects" (leverage of manager, or "bandwagon externalities")

 Entertainment & sports Madonna, U2 $50 M; M Jordan, Shaq $20M+, Alex Rodrigues $250M (AR package more than GDP of Cambodia)  Law & investment banking

41 More highly-paid (salary) Inv Bankers at Goldman Sachs than in all of Fortune 250 CEO's (c 1995)

 Government Wages relatively low (Congress $145K/yr, Pres $400k) Singapore $500-$800k (1995) Tradeoff: Low wages (US) exclude some talented people; But also select people who enter politics to "do some good"

 Teachers $43k (2002 US average)

E. To corporate profits. CEO comp was 8% of corporate profits in 2000 (Balsam, 2002) (1500 ExecuComp firms).

2. How to pay top executives?

Stock. Quote from Hall (03):

Interesting point about this quote...it compares a top manager to a home renter. Renters are more likely to have wild parties, damage floors, clog the toilets, etc. (familiar moral hazard/hidden action problems). But a top manager has been carefully selected for presumably knowing the business and having a moral sense of obligation and fiduciary responsibility to the stakeholders in the organization. Isn’t a top manager different than a renter?

Remark: Much of the faith in paying in stock is predicated on the “efficient markets hypothesis”, that the stock market is a good judge of the true value of the firm and hence a good “applause-o- meter” for judging the likely outcome of executive decisions. But what if the stock market can be tricked, is subject to fads, and so forth? Then paying in stock is not necessarily ideal....

Options:

42 See Hall Table 2. Imagine issuing either $100 of stock (at current price) or two at-the-money options worth $100 (total). If stock price goes up to 150, stock now worth 150. But two options are worth 183—83% return to CEO versus 50% return. This shows the leverage effect of options which induce more risk-taking. Note also that the stock and option packages are less valuable to the employees than they cost the firm. Issuing $100 costs $100; but because of risk-aversion the stock is only worth $85 (for typical CEO, very difficult calculation) and options worth only $65. So there is a value/cost “wedge” – it is like a gift that costs the firm $100 but is worth only $65 (for options) to CEO’s.

Brian Hall: “Six challenges” article

1. mismatched time horizons

goal is to sustain long-run value creation. Incentives which reward a brief run-up aren’t ideal. (In fact, option packages usually incentivize executives to run the stock up then down or down then up, rather than steady growth).

Solution: Slow “vesting period” (period of time over which the options/stock become owned by employee). Amazing fact: Most executive contracts have “accelerated” vesting when an exec announces retirement [Hall, p 25]. Produces exactly the wrong incentives—just when you are worried about retiring guys not paying attention, or helping out their pals, you speed up vesting of shares and options so they are even more short-term focussed. You really should not adjust or even stretch out the vesting period so that retiring CEO’s will have to live with the consequences of their decisions after they are retired.

43 2. gaming;

Larger option and stock pages incentivize CEO’s to trick the markets. Subtler than this: Options have huge upside potential and low downside. This is exactly the contract you would create if you wanted to encourage stock fraud. The point is that options encourage all kinds of risk-taking—big investment plans, daring acquistions, and outrageous scandal.

3. the value-cost "wedge"; (see Table 2)

value of options & stock to CEO’s is less than cost to the firm (due to presumed executive risk-aversion). This creates a loss from paying anything other than cash. The “wedge” or gap has to be made up by superior incentive properties of stock/options. NB: The size of this wedge was only discovered around 2000, after very subtle and careful calculation by Hall and Kevin J Murphy.

4. the leverage-fragility tradeoff;

fragility means the motivating power of options changes dramatically as the stock price rises—e.g. if options get “underwater” or “way out of the money” they have little motivating power (like getting way behind in a sports event—the incentive to work hard disappears if it is impossible to win). Fragility and leverage go hand in hand. Stocks have less leverage and are less fragile.

Often firms restrike the options at a lower strike price to restore the incentive. But this means the *initial* incentive effect is moderated—if the firm does badly the CEO is *not* penalized. Terrible idea! Best compromise: Issue steady flow of options which are struck at current stock price (this is what Intel does w/ my wife). This plan avoids the terrible idea of restriking options (rewarding bad performance), but giving new options adjusts for lost incentive effect of old options. Key is a fixed plan of future options and strike prices.

Amazingly, options are virtually never indexed to a market (or industry) benchmark. As a result, if a terrible manager runs a company in a boom market, he gets rich— through blind luck. This is absolutely shocking. Why? Who knows. One reason is that indexed options must be expensed on income statements. (Huh???). Prediction: 10 years from now virtually all options will be indexed.

5. aligning risk-taking incentives;

This is surprisingly—upon careful analysis, it is not clear that awarding options actually does create much risk-taking incentive. Also, what sort of risk-taking? Presumably the idea is to incentivize the combination of risk-taking and a long investment horizon.

6. avoiding excessive compensation.

44 Serious problem. More complex awards might make it easier to grab money. Boards are very incestuous—in about 73% (Shen data 98-01) the CEO is also Board Chairman. Stacked with pals. Many awards are outrageous. E.g. Steve Jobs (Apple) was awarded a $500 million options package. Wouldn’t say $10 million do the trick?

Problem is also that excess comp may reduce worker morale. Who wants to work hard in a firm run by a thief? (This is a serious problem in less-developed economies—the average person in the street just doesn’t trust the rich, and feels no stigma about minor crimes or transgression to get along.) This could have a huge cost.

Very wild idea: Compensation at this level must be largely symbolic. How much caviar, great skiing, champagne, and luxury cashmere can a CEO consume? So if that’s the case, why not coordinate substitution of some other symbolic system—but one that really matters—for money? Example: When John Reed (former Citigroup co-CEO) took over leadership of the New York Stock Exchange in 2003 (after boss Richard Grasso was embarassed by a $140 million deferred comp package and forced to quit), he said he would work for $1 per year. What about a system of awards, bestowed by fellow CEO’s, for “turnaround of the year” etc. Or awards voted upon by workers. These could be very powerful. A very well-paid CEO who is widely-hated would really wince when s/he found out the workers were really unhappy.

What do options really cost shareholders?

There is remarkable confusion about the true cost of options. Issuing options “dilutes” the firm because it spreads the firm’s value over more shareholders. See Table 1 below. New economy tech companies diluting shares by about 6% a year.

45 Confusion about true cost of dilution by giving shares & options ("And why shouldn't we let employers contribute their own stock to employee plans?…it's free. There's no cost at all. We should encourage employers to give their own stock, not prohibit it!" Elaine Chao, Secretary of Labor!!!)

Be careful of "bad" risk-taking (fraud, Bernie Ebbers etc) [i.e., careful accounting and strong governance is a "complement" with the issuance of options because issuing options gives great incentive for fraud]

Options issue may have encouraged CEOs to cook books, M&A sprees, etc.—insures them against downside risk from a catastrophe. I.e. options encourage risk-taking, but encourage all kinds of risk-taking…

Accounting issue: Should options be expensed like other compensation costs?

46 Pro: Yes, they are just like money. Not expensing creates an illusion; there is actual dilution that is not accounted for and reported to shareholders.

Con: Expensing makes them “more costly” (lowers short-term earnings) [huh? By this argument let’s not expense salary dollars]. Also not so easy to calculate option value (depends on likely lifetime, many other factors).

Do top management incentives work?

Key statistic is pay-for-performance sensitivity(PPS): CEO wealth/co. value Jensen-Murphy (1990): PPS is $2.50/$1000 Hall-Liebman (1998): PPS is $30/$1000  Huge increase in ten years.  If PPS was too low, now it’s probably ok.

What is the ideal PPS ? One measure: How much of the firm do CEO’s own? J-M 1990: CEO's own only .07% of shares Better? Measure: How much of CEO wealth is tied up in stock? J-M 1990: CEO shares/CEO wealth = 50% (That sounds reasonable; cf. venture capital, where entrepreneurs are forced to lose everything if their company fails)

Other incentives: Firing. Threat of firing is amazingly low (average CEO tenure is 10 years) Firing often accompanied by "golden parachutes" or extravagant severance pay (this should, in theory, be a reverse signal—any CEO who demands, up front, a terrific severance package is signaling that they are likely to be fired. Like “working without a net” in the circus, CEOs should “work without a ‘chute”)

Do firms with higher PPS do better? Yes in some studies, no in other studies. Stock market reacts positively to increase in CEO wealth/co. value

Problem: If stock options & stock are rewarded to incentivize CEO’s optimally, it should not be easy to undo their effects. If CEO’s get bushels of options and then exercise them immediately, their effect is weakened; similarly, if CEOs are awarded shares which they can sell without restriction, then we can measure whether they are getting “too many” shares by how many they sell. In fact, before 1990 or so, the ratio of selling of shares to buying by top managers (reported to SEC by law) was about 5-1. In recent years (2002-3) the ratio is an unbelievable 32-1. This seems like strong prima facie evidence that CEOs are getting too many shares, or that the shares are not sufficiently restricted.

47 Incentives gone wild, IV:

“Shielding”—does executive pay go down when a firm reports negative earnings? Answer: No.

(Sunjin Chen, 02) Regressions (Table 2) 2600 firms 1998-2001 regression change in log salary (CASH) or total compensation (TOTAL) on change in return on equity (ROE). In general, correlation with ROE is positive (.776, .340). But when ROE is negative, sum of pure effect plus adjustment (i.e. coefficients on ROE and neg_ROE added together) is +.069 (cash ) and +.014(total)

That is, pay goes up strongly when ROE increases, but *does not* fall when REO falls. This is called “shielding”.

*very important* (and only recently studied). Why? Because most high-power incentives (e.g. stock options) are designed to get executives to take risk. But this only works if CEO’s benefit on upside AND suffer on downside. If they don’t suffer on downside then there is too much motivation for bad behavior (e.g. fraud).

But...maybe shielding is the market’s way of saying that reporting negative ROE is not so bad. (Cf. DeGeorge-Patel-Zeckhauser). E.g. a good manager has “earnings in his pocket”—the ability to move around accounting-relevant sources of revenues and costs to avoid a loss. If a loss is inevitable, idea is to “take a bath” and maybe managers who do so are admired for consolidating losses into a one-time hit.

But...what if shielding is greater when firms are poorly governed (e.g. managerial entrenchment)? That would suggest shielding is not ideal, but is a trick entrenched CEO’s use to keep themselves from every losing (cf. “loss-aversion” in many many domains—people dislike losing more than they like equivalent win amounts).

48 49 50 51 Note that good monitoring increases ΔROE effect (-.57, -.60) and more managerial influence increases ΔROE effect (.339, .299). This suggests influential managers with a firm grip on their companies are raising the pay-for-performance sensitivity.

Effect on shielding is captured by *interaction* of MONIT and INFLU variables on the strength of the relationship with ΔNeg_ROE

Good monitoring reduces shielding ( MONITx ΔNeg .54,.80) (note this variable wipes out the negative coefficients -.678, -.524)

Managerial influence increases shielding (INFLUx ΔNeg -.45,-.29)

Bottom line: Shielding occurs because entrenched CEOs protect themselves from a drop in pay when ROE turns negative. But good monitoring erases the effect.

Peter Bonfield and John Weston recently received “Golden Parachutes,” much to the chagrin of shareholders

Pay for failure Galen Loram 08/03 exec compensation

The ratio of chief executive:average worker pay in the United States if 500:1. In Japan, it is closer to 10:1. Most Americans, however, accept this as they way things ought to be. The claim is that the high pay gives workers a reason to work hard (in hopes of winning the ‘tournament’ to be CEO), allows hiring of top talent, and acts as an incentive for the CEO to work hard, and to have them work for the company, as opposed to engaging activities such as empire-building. The idea of ‘pay for performance,’ where CEOs are given huge bonuses based on their company doing well (either in absolute terms or relative to their industry) is a similarly accepted phenomenon among US shareholders and workers.

These ideas do not fare as well abroad. Shareholder rebellions have become common since laws passed by the British Parliament required companies to disclose payments to top executives that became effective this year. Corporations from media firm Reuters to chemical and pharmaceutical giant Glaxo-SmithKlein to HSBC bank have all been the target of shareholder activism aimed at reducing what they see as exorbitant CEO pay.

Foreign investors seem willing to accept the pay for performance pay scheme of American CEOs; feathers have been ruffled over ‘golden parachutes.’ Golden parachutes are severance packages that are offered to CEOs and other top executives at the time of their hiring, offering them what often amounts to mllions of dollars in cash and benefits should they be fired. In the view of investors, this amounts to ‘pay for failure.’ In light of the fact that the average CEO tenure is 10 years, a CEO must perform very poorly to get fired, performing significantly worse than his predecessors or competitors for a number of years. Examples of these golden parachutes that have enraged Brits are the case of British Telecom, where CEO Peter Bonfield left the company with $100B in debt, but received a $10M severance package and BAE Systems John Weston who was fired after losing the company $1B, yet got a golden parachute worth $2.3M.

54 Why do companies employ these unpopular tactics? The risk of a recently-fired CEO refusing to ‘leave in peace’ is a daunting prospect. There is a chance that a CEO was fired for something that wasn’t their fault and would file a lawsuit for unfair termination of contract. The prospect of lawsuits, disclosures of unsavory facts about the company, and factionalism all pose a very real danger to a company. If a company is in a position where it is firing its CEO, it probably has not been doing well for the last couple of years, and really needs to be able to successfully turnaround. In the event that the turnaround fails, there is a decent chance that the company will fail as well – putting hundreds or thousands of employees out of business and shareholders holding stock not worth the paper it’s printed on. Thus a smooth transition with a CEO who will step aside gracefully, pass on the knowledge to has successor that needs to be passed on for organizational memory affords the company something that is worth more than the millions of dollars that they pay in severance packages – however this is often not apparent to stockholders and virtually any major changes will encounter resistance, so it is hardly surprising.

55 CEO power viewpoint

Bebchuck & Fried (J Ec Pers Summer 2003, 17, 71-92)

Claim: In conventional view, executive comp is a *solution* to an agency problem (i.e. how to align CEO and shareholder incentives) In “CEO power” view executive comp is *part* of the agency problem (i.e. CEOs compensate themselves in way that is often bad for shareholders)

Examples:

CEO control over board members (who controls who?) [cf parents and children—who is principal, who is agent? Natural view is that the parent is an agent for principal’s best interests. But parents may also use their kids to fulfill own needs for fame, pride etc (piano-playing daughter in Joy Luck Club, “stage parents” etc.]

If CEOs control board members, that can explain excessive compensation Evidence: Boards often elected as a slate. Why not one at a time?? Average director comp is high ($152k in 200 largest US companies, c2000) Director interlocks (A is often on B’s board and B is on A’s; so there is natural fear of reciprocity is A challenges B (then B can challenge A). Cf. “family marriages” among Medicis etc—creating interlocks is the best way (game theoretically) to guarantee cooperation. Or Pakistani villages in which brother A and sister A marry sister B and brother A. Then if A treats his wife (sister B) badly, her brother (brother B) will treat A’s sister badly.

Who sets pay? Board “compensation committee” Fact: Doubling Comp Comm. stock ownership reduces pay by 5%!? Large outside blockholder very powerful too Role of compensation consultants. Part of the conspiracy? They share info so CEOs know how much others make Ratchet effect—most pay in upper 50%...equilibrum is infinity!

Is pay hidden? Yes. 75% of 1500 largest firms lend money at “market rates” 56 (loophole: firm can define “market rate”) If loan is to buy stock, often “forgiven” (partially) if stock drops. Don’t have to report implicit compensation from below-market rates in SEC filed comp tables

Penalties for failure? No: In fact, often CEOs are paid to leave. Good CEO should signal skill by *not* insisting on generous severance. Why pay to leave? Must “force” CEOs to resign…why? Board has legal power to fire.

Compensation structure Few “no-windfall” provisions. (only 5% of large firms use reduced- windfall options; indexed options must be expensed as compn) At-the-money options: Out-of-the money has higher leverage Freedom to “unwind” Need lock-in/blackout, slow vesting etc (relatively rare)

What happens when CEO’s switch firms? Claim: Fact that pay is still high means it is not just grabbing local “rents” (Hall & Murphy) …But CEO’s wouldn’t move for less. New board etc can still be captured by *prospective* CEO. Are CEO’s participating in a widespread social convention/conspiracy?

Why isn’t there competition for these jobs/pressure to cut wages? Transparency + self-serving bias ratchet effect (like throwing water on an electric fire) . 1992 SEC ruling made sure CEO’s knew what others earned and Board interlocks make it hard to cut pay CEOs all know each other & are friends (elite conspiracy??) Headhunters say “not everyone can be a CEO”. Perhaps compensation consultants “legitimize” pay by serving as a lightning rod for blame

57 Governance:

Gompers-Metrick QJE paper

Idea is to mimick studies of economic growth—distinguish corporate democracies from dictatorships and see who does better in 1990s. In some ways companies are like democracies—shareholders vote for board members who oversee the company. But in other ways they are like dictatorships—the board proposes a full slate, has freedom (depending on state laws) to adopt various provisions which enhance CEO power etc.

Data: 1500 firms 1990-98

22 measures of governance (see Table 1) see below

58 form an index by adding up 1-0 all 22 indices

59 do “corporate democracies” work better? Yes…see operating returns (also more profitable stock investments, about .7%/month=8%+/yr (i.e. return on high-dem minus high-dictator portfolios)

60 61 Restructing, LBOs and Governance

Mergers (Andrade et al)

Facts about mergers: Tend to come in waves (Fig 1 Andrade et al) 1960's: Smaller (thin line < dotted) conglomerate acquisitions some of this is pointless diversification. Like going to a groupo dinner and each person orders the combination plate and everyone passes the combination plate around. Most stockholders are fairly diversified already because they own many stocks…so no need to diversify within each stock (unless it is managerial risk that is being diversified—e.g. in the group dinner what if each person was in charge of ordering one dish, then all the dishes were passed around. If the one person is afraid of being “fired” if they order a bad dish, could get combination-of-combination results…) 1986-98: Big conglomeration-- media (AOL/TimeWarner), metals, etc. Some consolidation in shrinking industries (larger scale economies in steel and overseas competition) some relaxation of antitrust attitudes against large mergers (e.g. Figure 2 shows % of mergers from deregulated industries). One viewpoint: Regulation was preventing consolidation and too much concentration in a few firms’ hands. Other viewpoint: Regulation kept inefficient firms alive; deregulation permitted low-cost and best firms to buy up the others and run them better. Latter probably true in airlines.

62 Winners: Target firms almost always have a big premium (Table 4) Mild losers … acquiring firms (zero gain to small loss) Hubris?? Persistent losers…acquiring firms financing with stock ("tricking" the market by using inflated stock to acquire-- e.g. AOL/Time Warner??). When firm “pays” with its own shares it signals to market that the shares were overpriced.

63 LBO's

Highly leveraged buyouts by outside investors (typically LBO firm with inside management)

Why work? Effective for squeezing fat…or transferring wealth from labor/stakholders to shareholders?

Good run of "good" LBO's in the 1980s till c 1990. Starting 1986 or so, poor interest coverage (cash flow/(interest+.5repayin2yrs) falls from 70% in early 1980s to 40%); more participation by old managers (guys hanging on to firms they ran badly); inv banking fees go from 2.5% to 6%!! Then "low fruit" taken, poor returns and some spectacular defaults

Three theories of early LBO success

Eclipse/superior form theory (Jensen) (LBO a better lifestyle) "equity is a pillow, debt is a sword" when default occurs, easy to reorganize w/o using bankruptcy courts

64 (small group of debtors)

"Radical diet" (cognitive) theory (need discipline of debt to downsize) debt payment creates sharp, clear goal to shoot for provides credible excuse to limit influence costs ("can't afford it")

Breach of trust theory (Shleifer and Summers, 1988)

(shareholder gains financed from breaching implicit contracts with workers and communities (e.g. Youngstown) E.g. think of typical wage-productivity profile (wages slope up, productivity peaks at c age 50). Who is the "overpaid worker"? Old guys!! But they are "overpaid" as part of a system of promising job security after underpaying for years…

Other changes in corporate governance (fall of the LBO) c. 1990s rise in shareholder activism (e.g. CALPERS) stock options

Holmstrom and Kaplan point:

(p 137) When are markets superior agents of change?

A. "Markets are more effective than managers when it comes to moving capital from declining industries to emerging industries" .

Why? "asking a corp to migrate between businesses … exacerbates internal conflicts"

B. Do markets have an "outside view"? That is, can they see the merit in new projects by looking objectively at a wide range of projects so the best ones stand out?

Interesting question: Would Netscape, eBay, Amazon have been capitalized appropriately from INSIDE Microsoft, Butterfields, or Barnes & Noble? (cf PC at XeroxPARC).

The argument depends on "vision" (overenthusiasm) of capital markets. Maybe capital markets are just better at taking a portfolio of risks and hoping some pan out (e.g. venture capitalists don’t fire other VC’s when one deal goes sour—they expect a lot of losers).

Even when markets "go overboard" net effect may be good? (Tech bubble)

65 Ethics: Should managers do anything other than make profit?

Ethical standards: Utilitarian (greatest good for greatest number) Moral relativists (depends) Kantians (good deeds count)

Agreed-upon norms (e.g. how much cheating on Wall St)

"Would you want it reported on the front of the Wall St Journal?" ethics standard

cost-benefit test: Put responsibility on "low cost avoider" E.g. if it is easy for people to become informed, use a "caveat emptor" (buyer beware) rule; if it is hard for people to become informed, use a "duty to disclose" rule (burden on the seller)

Conservative claim: "Social responsibility of business is to make profit"

Claim is that protecting consumers and workers is up to people themselves, unions, government regulation, etc. [Irony: Conservatives who use this argument tend to be those who distrust government to regulate effectively etc.] Coca-Cola exec: “Governments are for civic needs. Philanthropies are for social needs. Companies are for economic needs.”

But what if corporations are the "low cost avoiders". E.g. suppose you make a product which, if unsafe, wouldn't be revealed for 20 years-- manager is gone and firm might be bankrupt, so government and consumer policing are weak. Why not have a moral standard for managers which is overseen by directors?

Enlightened self-interest (don’t wash bath towels in hotels) Casinos packaging leftover food to feed the hungry (and satisfy legal charity requirement)

“Clientele effects”

Milton Friedman: the problem “the corporate executive would be spending someone else’s money for a general social interest…[when] the stockholders or the customers or the employees could separately spend their own money on the particular action if they wished to do so.” But maybe companies are more efficient at giving? (tax break too)

66 But what if corporations are the "low cost avoiders". E.g. suppose you make a product which, if unsafe, wouldn't be revealed for 20 years-- manager is gone and firm might be bankrupt, so government and consumer policing are weak. Why not have a moral standard for managers which is overseen by directors?

Margaret Blair, "Shareholder value, corporate governance…"

Claim: There is a shareholder primacy model which has taken over post-1980. Model is based on various principles. Some principles are clearly wrong or empirically poorly-founded. A broader model of "stakeholder" or "team" management is proposed (but it's vague).

The basis for shareholder primacy:

Critique

 Maximizing shareholder value max's all other claims (since shareholders are last in line)

Only true if other claimants are legally well protected and informed. E.g. managers can shift value from debt to equity by taking more risk (since debtholders suffer from bad outcomes and stockholders benefit from good outcomes). Workers have pensions, but managers can invest pensions in risky ways. Workers and customers care about safety, but managers can lie about safety. Reputation, legal liability etc., can mitigate lying, but only partially.

 Financial markets match stock prices to firm's true valuation

Very dubious, esp for new ventures (e.g. high tech). If markets do not price shares correctly, managers will (i) spend time pumping up stock price (e.g. accounting manipulation); (ii) overinvest in glamorous investment; (iii) underinvest in stuff the market doesn't price.

 Maximizing shareholder value gives managers a clear, publicly observable metric

Reasonable point. But there are other metrics (earnings, environmental scorecard, worker satisfaction) which are almost as clear.

 Managers will come closer to stock price maximization if they have "high powered incentives" (shares, options)

Reasonable point. Shares are good but options are very fragile (because of nonlinearity, it is easy to create a bad options package). Dirty secret of compensation literature: Options are designed to get managers to take more risk, to offset other incentives against risk-taking (e.g. career concerns). But how much more risk? Nobody knows. Nobody knows what the correct options package is. Furthermore, long-term options (e.g. 5 yrs) are a bad idea. Why? After 1 yr, stock is either up or down. Up options are "in the money" and induce less risk-taking (they are 67 like shares). Down options are "under water" and also induce less risk-taking. Often they are "restruck" at a lower strike price which means that bad short-run performance is not penalized. Options also "dilute" value of shares (spread firm around more owners) though they are not expensed (bad accounting mistake).

 Corporate law requires shareholder primacy. Should spread to other countries.

Not true. Law requires "director primacy". Shareholders vote annually on directors & some big events (liquidation, takeover) but otherwise have little power. (Like democracy-- citizens have power to vote, all other direct power in hands of elected & appointed officials).

Key point about "exporting the American model" is that it requires a lot of supporting institutions-- chiefly, actively-researched capital markets, good accounting disclosure, a free press, a trusted and informed judiciary (to settle suits properly), good consumer regulation…in short, if you are going to give shareholders the keys to the firm then you need to be sure other groups (workers, customers, debtors) are protected by other institutions.

If not shareholder primacy, what should directors do? Friedman: "The social responsibility of business is to make profits" (…because consumers have safety regulation, workers have unions & mobility, debtholders have lawyers…)

Blair-Stout: "the corporate form of organization can be seen as a legal mechanism that facilitates cooperation among team members…"

"An important role of directors in this model is to serve as the mediators for team members"--“make sure the game is played fairly and well”

CFC: Directors should stick up for weakest team members (while avoiding moral hazard of giving the “weak”– e.g., uninformed shareholders—no incentive to build strength).

Current model: Since shareholders are last in line, they have an incentive to maximize wealth created and expropriate from others (exploit labor, make shoddy products, use dubious accounting, etc.).

Proposed model: Directors are paternalistic-- they try to maximize shareholder value, while respecting the implicit contracts with workers and customers, and resisting temptations to breach those implicit contracts. Directors protect weak team members from exploitation (moral duty) when other mechanisms work poorly (e.g. product safety, worker wages & pension promises, etc.).

Culture & ethics Galen Loram 08/03

68 IBP:

Iowa Beef Packers, founded in 1960 by two former executives at Swift & Company, was one of the first companies in the meat packing business to eliminate the need for skilled workers. Each worker stood in the same place all day, using a ‘disassembly line’ to take apart animals for packing. The revolution that was started by IBP – cutting wages, employing unskilled workers and moving closer to the feedlots – embraced the western mentality of being incredibly tough. And the founders of IBP were tougher than anyone in the competition. They were not above dealing with the mob to crush unionization attempts, having been convicted for it in 1974, and relentlessly maximized the efficiency of their plants. While IBP maintains that it does not knowingly hire illegal immigrants, estimates by the INS suggest that 1/4th of the meatpackers in the heartland are illegal aliens. During a federal hearing in the 1980s the head of labor relations at IBP explained why the company did not try and limit it’s nearly 100% turnover rate annually: “We found very little correlation between turnover and profitability… For instance, insurance, as you know, is very costly. Insurance is not available to new employees until they’ve worked there for a period o a year or, in some cases, six months. Vacations don’t accrue until the second year. There are some economies, frankly, that result from hiring new employees.” Furthermore, IBP was fined $2.6 million by OSHA (Occupational Safety and Healthy Administration) for underreporting injuries at one of it’s plants and $3.1 million for “the high rate of cumulative trauma injuries” at one of their plants.

A surprise came when IBP hired Michael Ferrell went to a plant in Palestine, Texas after a series of accidents. One worker lost an arm in a bone-crushing machine, another was killed by an explosion. He found faulty wiring, disabled safety mechanisms and a cooling system that did not meet OSHA standards. In order to remedy these he shut down the slaughterhouse. Two months later, he was fired. Ironically, the two sides claim the same thing, though they use different words. Ferrell claims he was fired for ordering the plant shut down. IBP claims that he “never fit into IBP’s corporate culture” and “delegated too much authority.” Based on the fact that these claims are nearly identical, it seems likely that it is the case. IBP’s diehard culture does not embrace the notion of shutting down a plant to fix it, while that notion flew in the face of Ferrell’s vision of worker safety.

Works Cited

Schlosser, Eric. Fast Food Nation. 2001. New York: Harper Collins Publishing, 2002. 151-183.

69 Strategy and entrepreneurship

Core competence

Venture capital contracts

70 Guns, Golf and Greed

Galen Loram material for “core competence” O8/03

Apparently some executive at Smith & Wesson was watching “The Sopranos” when Tony Soprano polishes his gun while playing golf. At the end of 2002 renowned gun maker Smith & Wesson announced a deal with Vadersen Design Group, a firm Smith and Wesson describes as “prominent maker of high-quality golf clubs. Vadersen Design Group is Ernie Vadersen’s third attempt at a golf club manufacturing firm and appears to have negligible market share. His previous two firms, Ernie Vadersen Golf, Inc. and Snake Eyes Golf Clubs, Inc. both have gone bankrupt. All evidence points towards Vadersen Design Group having been s created solely for the purpose of this merger – of 225 pages mentioning it 221 also mention Smith & Wesson. With post September 11th sales up 83%, Smith & Wesson has an excess of cash and has started to diversify from its core business of firearms. While the company has been producing the heads for clubs for Vadersen for a few years, their name has never appeared on the club itself. This raises the question – what is Smith & Wesson doing in the golf club market? The club heads that they manufactured – the “Snake Eyes” sand and lob wedges – have been popular. Industry analysts mention that while S&W’s reputation “will intrigue some, it will be the products’ performance that matters most.’ In addition, the golf market is notoriously hard to gain a foothold in: Nike recently made an attempt and despite a 5 year $100 million endorsement from Tiger Woods has managed a meager 4% market share in the golf ball market and figures are not yet available for its foray into the club market which began in October 2002.

71 S&W seems to believe their core competence is in ‘metal objects that make things go a long way.’ Citing experience in metallurgy and a strong customer base in the appropriate demographic (men aged 25-55 with incomes greater than $60,000); executives at S&W seem confident that their foray into this new market will succeed. Furthermore, both are sporting goods and can be used by leaders of organizations (be it countries or corporations) to solve disputes. If it does succeed, what’s next? Smith and Wesson little league aluminum bats? Smith and Wesson space shuttle launchers? Or perhaps we’ll see a Jack Daniels single-barrel baby’s formula.

Works Cited

Frammolino, Ralph. “Gun Maker Smith & Wesson Sets Sights on New Line of Products: Golf

Clubs.” Los Angeles Times [Los Angeles] 24 Dec. 2002: 1C+.

Miller, Michael S. Shooting Better Golf Scores. 26 June 2003

72 [NOTE ALL MATERIAL FROM THIS POINT ON IS OPTIONAL FOR FALL 03 CLASS, WE WILL NOT HAVE TIME FOR THIS MATERIAL AND WON’T BE ON FINAL]

Ch 20 Regulation and business/govt relations How does govt influence business? Ideal:  Establish and enforce property rights (theft, contract, land)  Partially cure "market failures"  Redistribute wealth (tax and spend)

Property rights Governments use court systems etc. (police, mediation) to enforce property rights. Take this for granted in developed economies w/ exceptions (patents, use of names e.g. Tomy's Burgers…) Lawsuits also convey information to business mgrs & overcome consumer collective action problems (McDonald's "hot coffee" case; fen-fen class action; Blockbuster overcharge class action…)

Market failures  Public goods Nonexcludable, nonrivalrous consump'n (defense, clean air & water, reputation…) Financed by mandatory taxation & spending "Voting with your feet" allows cross-state diffs (Tiebout hypothesis)  Information (product safety, car recalls, accounting & finance…) requires disclosure and standardization (for comparison) cf. paternalism-- mandate choices by (c 1800) "idiots, women & minors"  Externalities Action of A is "external" to contract with B E.g., Chinese "haze" drifting to Canada/US, noise,… Coase theorem: Externalities self-internalize if t-costs are low

 Monopoly & market power/anti trust Limit anticompetitive effects and deadweight losses

Redistribution of wealth

"Robin Hood" taxation (most countries have convex marginal rates, except for social security)

73 "Rent seeking" competition for wealth among special political constitutents (aka "pork" as in "pork barrel politics")

Examples: (i) Farm states are among the most Republican and anti-government…but are also heavily supported by farm support/subdsidy programs (in some states in 02 drought year, half the farm income from government) See http://www.fsa.usda.gov/dafp/psd/programs.htm http://www.ewg.org/farm/ (search for biggest peanut buy-out beneficiaries)

(ii) Private oil leases purchased by auction were "cancelled" and repurchased by the govt in Florida 02. Why? (Hint: Do Floridians want oil messing up their beaches? Who's the Gov? Who's the President?)

Note: Language is key! Who couldn't be against "price stability" or a "recourse loan program" for honey-growers? Or "crop conservation" Aka psychology "framing effects"

How do regulations/law come about?

Demand side: Special interests coordinate and solve "collective action" problems, esp w/ Congressional system E.g., NRA gun lobby, tobacco ("sponsoring" TV ad ban?), helium reserve, local sports stadiums, NYC milk freshness,…

Public pressure (often idiosyncratic and fickle)

Supply side: Politicians enact laws. Courts interpret law & "make law".

Tort cases & policing of safety etc. (example: Unocal in Burma)

Socially Responsible Investing (these notes were prepared by Anita Choi):

Socially Responsible Investing (SRI)= Integrating personal values and societal concerns with investment decisions

Esp popular among institutions like foundations, nonprofit organizations, churches and synagogues.

3 key strategies in SRI: 1. Screening out (or in ) companies based on social or environmental criteria. E.g., respectable employee relations, strong records of community involvement, excellent environmental impact policies and practices, respect for human rights around the world, and safe and useful products. Conversely, they often avoid investments in those firms that fall short in these areas. (special kind is social venture capital).

74 Tobacco is the most widely screened out product category.

2 – Shareholder advocacy (activism). "Began" 1970s when religious investors formed a coalition (the Interfaith Center on Corporate Responsibility) to advocate socially responsible changes in corporate policies. Examples:

 Ending apartheid in South Africa through corporate divestment (huge success)

 Restricting harmful infant formula marketing by pharmaceutical companies in developing countries;  Getting companies like General Motors, Ford Motor Company, and Sun Company to sign the CERES Principles, which require efforts to reduce pollution and increase environmental disclosure;

3 –Community Investment describes investing that supports development initiatives in low- income communities in the US and developing countries (very big "microlending" in developing countries where tiny loans, like $100, can go a long way). Mainly through 4 types of institutions: community banks, community credit unions, community loan funds, and microenterprise lenders.

SRI Funds growing rapidly ($2 trillion in 2001, about 10% of $20 trillion professionally managed), 99-01 about 50% faster than total fund inflow. Total 230 mutual funds.

Examples of shareholder advocacy:

ExxonMobil

On May 29th, 2002, concerned shareholders presented a resolution at ExxonMobil's annual shareholders' meeting, asking the company to diversify its energy mix during a time of dwindling international oil reserves, by investing more research and funds into renewable energy sources. This was the third year the resolution was filed, and it received 20.3% of the vote. The proposal was also supported by the largest public pension fund in the world-CalPERS (California Public Employees Retirement System), and Institutional Shareholder Services, the U.S.'s largest proxy voting advisory firm.

Shareholder advocates believe that ExxonMobil, by solely focusing on cheap fossil fuels, has been left out of the emerging profit sector of renewable energy. At the same time, its ongoing denial of climactic effects from fossil fuel burning is increasingly isolating itself from the innovative policies and strategies of its main international competitors--such as Shell and BP. Because of this, ExxonMobil will be facing substantial financial and environmental liabilities in the years to come:

 ExxonMobil does not currently incorporate any significant solar, biomass, or other renewable energy production in its energy mix.  The effects of global warming (caused in part by fossil fuel use) pose risks of devaluation for long-term investments in many economic sectors. The United Nations Environment

75 Programme's Financial Services Initiative projects that rising sea levels, increased incidence of tropical storms, and loss of water and agricultural resources will result in annual worldwide costs to reach $304.2 billion annually by 2050.  ExxonMobil's long-term investments are in danger of devaluation due to carbon risks associated with continued reliance on fossil fuels. In the future, climate change redress may be sought in the courts; ExxonMobil could be a target for litigation if it maintains its position as an oil and gas giant, rather than an energy company with a diversified, cleaner energy mix.

Walmart

Shareholders are currently in dialogue with executives at Wal-Mart Stores concerning sweatshop labor abuses in Wal-Mart supply chains. A few years ago, Wal-Mart executives had agreed to initiate an independent monitoring pilot project that could serve as a model for many retailing industries. Wal-Mart later announced it had decided to cancel the pilot project. Shareholders at that point decided to file a resolution at the world's largest retailer, asking the company to improve working conditions in its supply chains to mitigate worker abuse liabilities the company may be facing.

A Business Week investigation (10/2/00) of the company's supplier plant in Zhongshan, China found serious labor abuses that Wal-Mart's own monitors had missed. Independent monitoring, encouraged by filing shareholders, would reduce the risk of such abuses, as well as consumer boycotts, potential damage to Wal-Mart's reputation, exposure to negative media, worker law suits, and divestiture by institutional investors. It would also improve consumer confidence in the company and customer loyalty.

But… can advocacy go to far (extortion)? E.g., some minority groups have been accused of extorting money by threatening to file lawsuits about labor discrimination etc unless the accused donates money to a center (Jesse Jackson et al). Suppose media reportage can be misleading and lead to too much distrust of a company. What motivates advocates to create the right degree of incentive?