Bounded Rationality, Private Information, Moral Hazard and Performance Incentive

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Bounded Rationality, Private Information, Moral Hazard and Performance Incentives [A Summarized Reconstruction of Chapters 5 and 6 of Economics, Organization and Management (1992, Prentice Hall) by Paul Milgrom and John Roberts]

Prepared By: Rajib Sarkar
11th January 2012

Introduction
Firms exist to coordinate and motivate the economic activities of a set of interconnected individuals. When individuals specialize in their production activities (the division of labour), economy of scale and learning curve help to achieve considerable gains in efficiency. But once people specialize, they become mutually dependent, because no one produces by herself all the things she needs. Indeed, in most contexts in a modern economy, an individual in her job actually produces nothing she may personally want to consume. Instead, she exchanges the limited set of things she does produce for the vast variety of goods and services that she actually wants and others make. These interdependencies mean that there is a need to coordinate different individuals’ activities and to motivate them. Coordination means, at the least, that all the required tasks are carried out without unnecessary duplication. Further, it seeks to ensure that the tasks are done efficiently, by the right people, in the right way, and at the right time and place. Full coordination also requires that the tasks actually undertaken are the right ones. In other words, both effectiveness and efficiency are of essence in coordination. In the context of the firm, this means that the activities indicated by the strategy are executed in a cost-minimizing fashion and that the execution of the strategy creates as much value as possible. Finding a solution to the coordination problem involves grappling with complexities, even in relatively simple contexts, because all organizations are multidimensional systems of various independent parts. Motivation becomes a problem too, because it may not automatically be in the self-interest of individuals or groups to act in ways that achieve an efficient solution to the coordination problem. Generally, we might expect that the people are somewhat selfish. This is not to deny elements of altruism in humans, but to indicate that pure altruism is unlikely. Most people most of the times, would like to receive more of the things they value; even if in so doing they deny others the benefits of these things. Further, they will want to avoid as much of the costs of economic activity as they can, even if others have to bear somewhat higher costs as a result. In the presence of independencies, individuals’ attempts to grab more of the benefits and avoid the costs can make everyone including themselves, much worse off than if they behaved differently. The issue is then to motivate people so they choose to behave in ways that are conducive to realizing a coordinated solution. Markets are one very prominent mechanism for solving the problem of coordination and motivation. Market institutions leave individuals to pursue self-interested behavior, but guide their choices by the prices they pay and receive. A well-functioning market leads the interdependencies among people to be fully “internalized”. Interdependence means that one person’s choices and actions have an impact on other people. Prices in well-functioning markets simultaneously reflect the benefits of an extra unit to buyers and its cost to sellers; so price-guided choices bring these marginal costs and benefits into equality. In essence, market prices signal what needs to be done, when, where and how, and by whom. In so doing, markets achieve a remarkable level of coordination any conscious central planning or control. Moreover, markets provide intense individual incentives for innovation, investments, and effort; they require minimal amounts of formal amounts of formal communications about opportunities, needs, and resources; and they allow for unmatched...
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