9781118041581

Organizational Design 605

arrangement raise the incentive to supply extra effort? The answer is yes. As

shown in item 4 of Table 14.3b, the worker maximizes his or her profit (salary

less disutility) by choosing a mediumlevel of effort. The incentive contract has

induced additional effort and has increased the total profit pie. Nevertheless,

the worker still does not have sufficient incentive to adopt optimal behavior,

that is, exert high effort. (Under high effort, the worker’s expected compen-

sation is (.5)(85,000) 10,000 $52,500. Thus, the worker’s net profit is

52,500 45,000 $7,500, or $1,000 less than the medium-effort outcome.)

As this example shows, raising the worker’s profit share is the key to induc-

ing extra effort. In fact, allowing the worker to keep 100 percent of his or her con-

tribution to profit ensures an optimal choice of effort. Now the worker’s interest

is identical to the overall objective of profit maximization. Taking full account of

the extra benefits and costs (disutility) of additional effort, the worker adopts

optimal behavior. Unfortunately, even this solution has problems. First, 100 per-

cent profit participation represents a very risky contract for the worker. After all,

the gross profit outcome in Table 14.3 will be either $100,000 or $50,000. That’s

a significant risk. Any risk-averse worker will demand a premium for bearing this

risk. To put this another way, besides the disutility of effort, the personal “cost”

to the worker associated with risk bearing could well be on the order of $5,000

or more. Thus, imposing this risk on the worker shrinks the total pie by this

amount. Second, under the terms of the contract, the worker guarantees the

employer a profit of $25,000. Because the employer has a guaranteed profit, the

employer’s incentives are negligible. But typically, the employer’s actions and

efforts will contribute to the worker’s ultimate output. Now the proverbial moral

hazard shoe is on the other foot. Will the employer adopt optimal behavior?

Absent incentives, the answer is problematic.

In the interest of realism, we can generalize this stylized example and

extend it in a number of directions. (The appendix to this chapter presents

just such an extended model.) Whatever the specific model, the degree of con-

tractual incentives remains the key issue. Suppose that (1) the worker’s output

depends mainly on effort (and only partly on factors beyond his or her con-

trol); and (2) his or her choice of effort has a large impact on profit. Both of

these factors argue for high-powered incentives (i.e., high profit-sharing rates).

As in the preceding example, profit sharing induces greater worker effort, mit-

igating (though not eliminating) the moral hazard problem.

Should a firm sell its product in its own stores or instead by contracting with

a franchisee? As we noted in Chapter 2, the franchise arrangement embodies

high-powered incentives for the franchisee; the franchise manager’s effort

and choices directly influence the franchise’s profits. By contrast, under an

employment relationship, the employee typically faces low-powered incen-

tives; typically the employee has limited managerial discretion and little (or

zero) profit sharing.

Integration or

Franchising?

c14AsymmetricInformationandOrganizationalDesign.qxd 9/26/11 11:03 AM Page 605