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Transfer Pricing
Nobody talked about an alternative to transfer pricing - off the top funding. Even in for profit companies certain departments, like HR (human resources) and IT (information technology) are typically funded off the top. Off the top funding is preferred to transfer pricing when sizing the department is not a big concern. Off the top funding encourages greater utilization of that department's services. Transfer pricing is preferred to off the top funding when the sizing of activity is a critical aspect of firm operation. If the upstream offering is from an undersized division, that can create costly bottlenecks for the firm. Alternatively if the capacity the upstream division requires is very costly, having that capacity go idle frequently can significantly lower profits. Transfer pricing is better than off the top funding at getting the size right.
Only a few people mentioned the possibility of an outside market and nobody really asked why there is this upstream division in the first place. You may recall that earlier in the semester we talked about asset specificity and hold up. This is typically why the firm is vertically integrated and why transfer pricing becomes an issue. But there may be other possible suppliers in the market and the downstream division might consider outsourcing to them as an alternative to buying from the upstream division or in addition to that. In this case the transfer price will be influenced by the market price. In the textbook case where the market provides a perfect substitute to what the upstream division provides, then it is optimal for the transfer price to coincide with the market price.
There is a puzzle with regard to the following. If divisional profits ultimately go to shareholders, why should the divisions care about how much profit they make? The response to this is that divisional profits are utilized as part of the performance measure about how well division management is doing. Another part of that performance measure might very well be overall company profit. In other words, the upstream division will want the transfer price to be higher than where social surplus is maximized, but it may not want it to be as high as the monopoly price. Most people ignored the possibility that the performance measure could be other than divisional profit only.
Last, only a few people mentioned the use of transfer prices as a means to avoid paying corporate profit taxes. We didn't discuss this in class, but there was an Econ in the News post to the class site on Apple, in particular, exploiting transfer prices in this way.
Conflict
Answers were generally okay. Many people associated the expression "my way or the highway" with Model 1. That was fine.
I would have liked students to ask more about why the employee should have something of value to contribute. The vast majority of the class simply assumed that the employees would have something to contribute. Might it be that in some cases they don't? Had students asked this question it would have better tied their response into things we studies earlier in the semester. Two possible sources of contributions are:
- employees have information that the manager doesn't have, from interaction with clients, interaction with other employees, interaction with contractors, or from use of products or services that the manager hasn't used.
- employees have expertise that the manager doesn't have.
The first instance should bring up a recollection of whether decisions are made by the center (manager) or at the edge (employee). Recall that we said economists generally favor decentralized decision making - make the decision where the information is. It would have been good to bring that earlier discussion in. Nobody did.
The problem with the earlier discussion is that it is either/or and many decisions are more complex than that, with multiple bits of information needing to be incorporated to make a good choice. This is why the inquiry approach advocated in model 2 makes sense. Inquiry is the way to address the complexity.
The second instance regarding differences in expertise may be worse on morale, when the opinions of the employee are ignored. In the first instance it is always possible that, unknown to the employee, the manager has other information that speaks to supporting what the manager has chosen. When the issue is expertise, however, the poor judgment of the manager is clearly evident to the more expert employee. There is no doubt then. That is demoralizing.
Nobody brought up the Casey Stengel line that I had us consider earlier in the semester:
The key to being a good manager is keeping the people who hate me away from those who are still undecided.
There are at least a couple of ways to interpret this and have the interpretation consistent with Argyris and Schon. First, the people who hate me in that quote are the ball players who are being platooned and want more playing time. They'll complain about that, but it is something the manager should ignore. Put a different way, sometimes the employee will want what is good for the employee but not necessarily good for the organization. Those suggestions should be ignored. The process of the employee communicating the suggestion and the manager ignoring it creates conflict, but in this case it is also consistent with higher productivity. Second, having people like each other may be secondary at work. What matters is that they respect one another and put in their best effort as a consequence. In the case of Casey Stengel as manager of the Yankees, the team won, spectacularly often. The winning was sufficient to cause the players to respect the manager, even if the individual players didn't get as much playing time as they wanted. Sometimes respect and likability go hand in hand. Other times they don't. It is respect that matters more for productivity.
Now for a sidebar on language use. The word authority has at least two distinct meanings. One is dictator. The other is expert. If a regime has a dictator, then it is referred to as authoritarian. Nazi Germany had an authoritarian regime under Adolf Hitler. If a person is known as an expert then his or her opinion is taken as authoritative, which means others should trust it willingly. There is an expression, "according to Hoyle" which originally meant that the rules (of the card game) were correct and has come to mean that the procedure being followed in any endeavor is correct. Hoyle was an expert on card games. Likewise, Judith Martin (Miss Manners) is an expert on etiquette. If you quote Miss Manners you are offering an authoritative view about the proper way to behave.
On this question several students wrote authoritative where they meant authoritarian. I didn't punish anyone for doing that, but I thought you should know the difference.
Incentives
Students seemed to struggle with this question. Many responses included incorrect assertions, among them:
- There is monitoring in the static principal-agent model (there isn't).
- Output is a deterministic function of effort in the static model so low effort produces low output and high effort produces high output. (Actually, output is a random function of effort and high effort make high output more likely, but it is not certain.)
- The equilibrium in each model can be improved upon by government interference (that's only true in the Shapiro-Stiglitz model).
- Referring to the equilibrium of the Shapiro-Stiglitz model as an optimum. (It is not optimal.)
There were a variety of other errors as well. Perhaps more importantly, some people couldn't describe these situation in their own words. They relied on the Excel homework (too much in my view) to characterize the equilibrium.
Looking at this performance, what I was asking was difficult for the class because you haven't practiced it before. The key notion is to be able to translate the formal model into a narrative that you could use to explain the ideas to somebody outside the class. It is an important skill to develop, in my class and in the rest of your study of economics as well.
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