9781118041581

Summary 617

believing they had little or no control over profits. The plan also raised tensions among

employees whose bonuses now depended on the efforts of others. Many workers blamed

management for wasting money and being a drag on profits. They resented the fact that

managers were protected by other bonus plans geared to firm-wide profits.

The failure to achieve the 1990 profit goal (set 4 percent above the 1989 goal), how-

ever, sealed the fate of the plan. With its principal customers—the automobile and hous-

ing industries—crippled by the 1990 economic recession, the fiber division’s profit

prospects were dismal. After earning a modest bonus in the first year, employees stood to

lose 2 to 4 percent of their pay in the second. This fact sealed the death of the plan.

The aforementioned problems are exactly in line with this chapter’s analysis. In effect,

the bonus system enrolled all fiber-division employees in a 20,000-person team! Although

one could spew bromides on how everyone should work together, the incentive effects drove

people apart. Any individual employee had virtually no impact on the division’s profits and

thus had little personal incentive to pay attention to profitability. Instead, part of the worker’s

compensation was placed at risk, determined by factors beyond his or her control. Indeed,

many workers rebelled at pay cuts triggered by the economic downturn, a factor they deemed

irrelevant as far as their performance was concerned. For all these reasons, the plan failed.

SUMMARY

Decision-Making Principles

1. Under asymmetric information, the decision maker must take into
   account the dual problems of adverse selection and moral hazard.


2. Many contractual relationships involve an agent in possession of superior
   information taking actions for another party. The principal must provide
   incentives or controls to induce the agent to act in the principal’s behalf.


3. Modern firms divide information and management responsibilities
   among a wide group of managers.


4. According to the efficiency principle, business firms will organize to
   minimize the total cost of production, including transaction costs.
   Designing an efficient organization involves determining the boundaries
   of the firm, assigning decision responsibilities to managers with the best
   information on which to act, and providing control and incentive
   systems to minimize agency costs.

Nuts and Bolts

1. Adverse selection occurs when the agent who has information that is
   unavailable to the principal self-selects in a manner detrimental to the
   principal. Warranties, contingent agreements, establishing a reputation,
   and signaling can help mitigate adverse selection problems.

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