Economic Analysis and Statecraft: Concepts and Tools (STG-MA-M7-ECA23)

STG-MA-M7-ECA23

Description

Incentives and contracts are at the center of all economic analysis.  

In these lectures we will analyze incentive provision recognizing that there is almost always asymmetric information of some sort between those providing the incentives and those responding to them. Employers have only limited knowledge of workers when they get hired. An insurance company does not know the riskiness of individual customers and how the customers respond to a particular insurance plan.  

Insurance companies were the first to use the term adverse selection in recognition of the fact that those who bought more insurance also tended to be greater risks for the companies. They coined the term moral hazard for a standard behavioral response to insurance: the more protection a plan provided, the more risky the behavior of the insured.  

Incentive design is a complex subject. For instance, piece rates may often lead workers to allocate their time to maximize quantity at the expense of quality. How big a problem this is depends on the context – what kinds of things can a worker do? What types of performance measures are readily available? Misalignment between what is desired and what can be measured is a major cause of poor incentive design. We will learn how to deal with these problems. There is rarely a perfect solution, so the objective is to come up with the one closest to the ideal. Such schemes are called second-best. 

Using financial incentives is just one of many ways to influence people’s incentives. The tasks assigned to workers, the authority they are given, the careers they are offered, the job environments and learning opportunities they are given and the personal attention and encouragement that are used, all influence worker behavior. The design of incentives involves orchestrating in the best way possible a whole array of incentive instruments. It is very much a system problem where coherence of the design is more important than the optimization of the individual components.  

Ownership is an especially important incentive driver. Private ownership is at the core of market economies. There are two main reasons for this. First, ownership gives a stake in the outcome of the enterprise. Second, ownership gives (usually) control over the way the enterprise is to be organized, what it should produce and what strategy it should follow. The value of control is significant, but it often ends up being shared. In large corporations, management often has effective control. The freedom of management versus the rights of shareholders in public corporations is actively debated today under the rubric of corporate governance. The perspective on incentive problems offered here sheds light on this debate, though we will not go into details of the subject. 

We end by discussing theories of the firm. Why do we have firms? What determines the boundaries of the firm? While joint stock companies are the most influential forms of firms, there are many other forms of organization. Partnerships, cooperatives, non-profits, clubs, and so on, play important roles as well. Why are these used and in what sorts of situations do they perform best?  

The underlying premise for explaining incentives and forms of organization is the assumption that people try to organize economic activities in the most efficient manner possible, that is, to create the largest possible pie to be shared among the economic agents involved. This efficiency premise is a key thread that runs throughout the different contexts of contracting and organization.