Organizational Form, Governance
and Mechanism Design
Chapter 15
• Coordination and control are problems for all business
organizations. The larger the organization, the larger the
problem.
• Contracts help insure performance, but most contracts
are incomplete. Goods are allocated in free markets by
using prices.
• However, there are alternative allocative mechanisms
that are adopted, such as waiting in line (queues) and
auctions the avoid prices.
2002 South-Western Publishing
Slide 1
Role of Business Contracting in
Cooperative Games
• The amount of advertising and service can be
viewed as a game.
• The outcome can be sub-optimal; that is, it is not
value maximizing. The cooperative solution
sometime yields better payoffs.
• To get to a value-maximizing solution, the
manufacturer may have to consider side
payments or credible commitments to the retailer.
Slide 2
Choice of Organizational Form
• A reliant asset is a non-redeployable durable asset.
Specialized equipment or specialized knowledge
cannot be transferred to other uses.
• In markets with reliant assets, one party could
“hold-up” the other party. The choice of
organization will require explicit contracts.
• The likely outcome is franchise contracts.
• Relational contracts are promissory agreements of
coordinated performance. A jet charter company is
a good example.
Slide 3
Vertical Requirements Contract
• A vertical requirements contract is one in
which the firms in successive stages of
production agree to payments and/or penalties
for taking an action.
• Contracts must assign penalties for not living
up to the agreement. These payments are part
of a several step sequential game.
» If the manufacturer spends a large amount to
advertise the product, the distributor promises to
promote the product as well.
Slide 4
Vertical Integration
• An alternative to contracts between two parties is
vertical integration. If the retailer and manufacturer
merge, then both interests are reflected in a decision
whether or not to advertise or expand service.
• Spot markets present few incentive or informational
problems.
» The purchase of a dozen ears of corn at a roadside stand or the
sale of electricity at a spot rate off the grid, are examples of
spot markets.
» The products are relatively standardized and sold for
immediate delivery.
Slide 5
Governance Mechanisms and the
Problem of Moral Hazard
• Establishing a price for a product or service in a market
involves a cost.
• Transaction cost economics - involves the issue of
finding the lowest cost organizational structure.
» In some cases it is cheapest to vertically integrate and avoid
markets.
» In other cases, firms create quasi-prices, known as transfer
prices, to create market-like pricing in a multi-divisional firm.
» Still others find that market relationships work best, by
buying and selling at arm's length prices.
» When only incomplete contracts are possible, it is often the
best to integrate the operations within a firm.
Slide 6
Moral Hazard
• Moral hazard occurs when parties change their
behavior due to contracts. This is especially
true when the people's effort is hard to observe.
• Consider a borrower-lender contract.
» A reliable borrower, once given money in a loan,
may elect to invest in high risk projects.
» To avoid this moral hazard, the bank may insist on
costly monitoring or governance actions, forcing the
borrow to submit frequent financial data.
Slide 7
An Optimal Design Mechanism
• What is the best way to
divide a deceased
individual’s estate?
• What mechanism will
encourage open
communication and a fair
division?
• These are the types of
issues discussed in finding
an optimal design.
• Fair division of a
decaying prize problem.
• Suppose the division of
an award between two
parties shrinks each time
one party refuses the
agreement.
• The incentive is created
to agree to a 50:50 split;
otherwise, the prize may
get smaller.
Slide 8
The Service Queue Problem:
Customers Wait in Line
• First-come, first-served  The people with the
lowest cost of time get the tickets.
• Last-come, first-served  removes the
incentive to wait in line. The best strategy is to
show up anytime, whenever the ticket window
is open.
• Stratified lotteries  advanced reservation
tickets are assigned different prices than last
minute walk-ups.
Slide 9
Auction Design and Information Economics
• Simultaneous bidding 
open outcry at estate
auctions. Information
about other bidders
valuation is revealed
» price discovery occurs
• Sequential bidding 
such as private placement
for newly issued
securities.
• Bid prices can be discrete
or continuous  by agreed
increments, as in 1/8 or
1/16 for stocks in the past
or any decimal price now.
• Bids can be sealed or
posted  sealed bids make
them anonymous and secret
to other bidders
• Bids can be one-time-only
or multiple rounds.
Slide 10
Types of Auctions
• In English auctions, the prices rise as more
bids arrive.
• In Dutch auctions, a high price is announced,
and if no one agrees, the auctioneer lowers the
price until the first bid arrives.
» If mineral rights to 1,000 acres of land were
auctioned, the winning bid may elect to
purchase less than 1,000 acres or rights.
• Reservation price  the minimum acceptable
bid.
Slide 11
Winner’s Curse
• If the true value of an item is not known, but bidders
have a distribution of values that they are willing to
pay, the winning bid is very likely to be higher than
the true value.
• The regret for the bidder is that he or she paid
too much: the winner’s curse.
• If everyone is aware of the winner’s curse, then all
would bid less than what they think is its true value.
This problem has led some auctions to award the
highest bidder with the second-best price in a sealed
bid auction. Even though you won, the price was a bit
lower than what you paid.
Slide 12
Information Revealed in
Common-Value Auctions
• Common-value auctions are ones where the bidders have
identical valuation of the item when information is complete.
• For simultaneous, sealed-bid auctions, the bidder offers prices
below their expected value.
» No information is conveyed to competitors.
• For simultaneous, open-bidding auctions, information is
revealed by the bids of others. One variation is multiple
rounds.
• Bidding for broadcast spectrum bidding, the FCC used 112
rounds over a four-month bidding period.
Slide 13
Strategic Underbidding in
Private-Value Auctions
• Private-value auctions are
•
where bidders have different
valuations for the item
•
• The highest value bidders may
wish to wait-and-see in English •
open outcry auctions.
• In sealed-bid auctions, this
•
strategy does not work.
• Even with sealed bidding, the
fear of the winners curse may •
lead to underbidding.
A Vickery auction is the secondhighest sealed bid auctions.
Second-highest sealed bids are
used to reduce underbidding.
Knowing that you pay less than
bid helps to move bid closer to
one’s private value.
As the number of bidders rises,
the percentage underbid tends to
decline.
Vickery shows the optimal
underbidding is 1/Nth the true
value, with N the number of
bidders.
Slide 14