618 Chapter 14 Asymmetric Information and Organizational Design- Moral hazard occurs when an agent takes unobservable or hidden
actions detrimental to the principal. Principals can design controls and
incentives to mitigate (though not eliminate) moral hazard problems.
The resulting reduction in welfare from moral hazard is frequently
labeled an agency cost. - A firm will choose to undertake an activity in-house rather than rely on
outsourcing when the activity requires a high degree of coordination or
where the input is highly specialized. - A firm will benefit from decentralized decision making when specialized
information is dispersed among different management segments and
when delegated decisions exhibit a low degree of interdependence. - Firms require control and incentive systems when an agent’s objective
differs from the firm’s. Compensating the agent the exact amount he or
she contributes to profit solves the incentive problem but exposes the
agent to additional risk. - The modern corporation is characterized by separation of ownership and
control. The owner-shareholders have little direct control over
management. However, performance incentives, the external enforcement
of executive duties, corporate governance reforms, and the market for
corporate control can help mitigate principal-agent problems.
Questions and Problems
- Carmakers acknowledge that a small percentage of new automobiles are
“lemons.” In the early 1980s, Chrysler Corporation succeeded in winning
back lost market share by offering buyers the chance to return their new
cars for up to 30 days if they were not satisfied. In this way, the “new”
Chrysler sought to demonstrate its confidence in product quality. Suppose
Chrysler made the following estimates for the program: (1) 4 percent of its
new cars were lemons; (2) one-half of all lemons would be discovered and
returned; and (3) 1 out of every 16 normal-quality cars would be returned
because of minor problems, buyer change of heart, and so on.
a. Of all the cars returned, what portion are lemons? For a buyer
satisfied after month 1, what is the chance that that person will later
find that he or she owns a lemon?
b. How might Chrysler decide whether the program’s benefits in
screening for quality are worth its costs? - In the early 1990s, lawsuits charged Sears with massive fraud in its auto
repair centers, alleging that mechanics were convincing customers that
they needed expensive repairs when, in fact, they were unnecessary.
Sears entered into a multimillion-dollar agreement to settle the case out
of court. In addition, in a bid to win back business it had lost during the
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