Residual control rights are the rights with respect to the use of an asset that are *not* otherwise allocated within a contract.
Suppose there exists a situation where two individuals transact, and absent incentive problems, efficiency would dictate that each make investments in human capital which may be relationship-specific. Assuming that the participants split the ex post gains from trade, they each will tend to underinvest. The extent to which they underinvest depends on their bargaining power. Bargaining power depends on each individual's outside opportunities -- what they can avail themselves of, given a breakdown in trade. Hart argues that the more physical assets an individual holds, the more his or her human capital investments are protected if and when breakdowns occur. The more individuals are protected, the greater incentive they have to invest in relationship-specific human capital.
2. According to Nelson and Winter, why would management be more difficult for firms in industries where there are intermittent, unanticipated breakthroughs in technological capabilities (for example, in biotechnology) than in those where technological capabilites remain relatively constant over long periods (for example, in sugar production)?
Management would be particularly difficult when there are intermittent, unanticipated technological changes because such changes imply that existing routines may not work particularly well. Management would involve adapting existing routines to new, very different situations, or inventing new routines to fit new environments. In contrast, management in static environments tends to be engaged in ensuring that existing routines work smoothly. The latter appears easier.
3. Mechanics, hair stylists, plumbers, and dentists may not share much
in common personally. But they do share several features professionally.
Discuss why individuals in these professions tend "own their clients," are paid mainly as a function of the work they complete, and tend to own many of their own tools.
[When thinking about your answer, it may help to consider why the opposite does not happen -- that is, think about what would happen if auto repair firms "owned clients," mechanics were not paid commissions, and mechanics did not own their own tools. If doing so does not help, though, feel free not to do this.]
Holmstrom and Milgrom's theory implies that individuals who are paid strong performance incentives tend to own their own tools and have wide discretion, whereas individuals who are paid weak performance incentives tend not to own their own tools and tend to have limited discretion. One feature of their model is that performance incentives, asset ownership, and discretion are incentive instruments. An implication of keeping them in balance is that the three incentive instruments are complementary. This explains why these instruments tend to be either all high (for independent contractors) or all low (for employees). So this explains the clustering of performance incentives, asset ownership, and discretion. It does not explain why these all tend to be high rather than low for these individuals.
[What is "discretion" in the context of these professions? Individuals tend be more able to set their own hours. They tend to have more of a right to accept or refuse work as they choose. Supervisors have a limited ability to reallocate customers from one hair stylist/dentist/auto repairer to another. This is the content of "owning your clients," and implies high discretion.]
So why do these indivduals tend to be independent contractors rather than employees? One explanation has to do with the costs of measuring "quality." It is relatively difficult for supervisors to measure service quality -- how good is the haircut, how thorough is the automotive repair, etc. Part of the reason for this is that quality is not apparent at the time of the transaction -- does the haircut look good after the customer showers and styles it himself or herself, how long did the auto repair last, etc. Customers may be better able to assess quality than supervisors. If this is the case, it may be efficient to allow customers ("the market") to monitor quality rather than using internal incentives. This would require these individuals to receive strong performance incentives -- and asset ownership and wide discretion follows by H&M's theory.
This was a particularly tough question for a couple of reasons. One is that applying H&M's theory directly, one would predict that service providers would be employees. H&M's theory implies that noisy measurement of any one task implies weak incentives all around. The fact that this prediction is inconsistent with the facts suggests that one needs to expand the theory or examine its assumptions. The answer above goes outside the theory by allowing customers to provide quality incentives. Another reason it is difficult is that we did not discuss any theories that applied directly to this circumstance.
Don't worry -- I will try not to ask such questions on the exam. But it is an interesting problem to consider on a problem set, when one has more time and is allow to discuss answers with others.
4. Salespeople at retail apparel stores generally have several responsibilities. One is that they are responsible for serving customers and encouraging them to purchase goods. Another is that they are responsible for keeping the store looking good. Part of this involves restocking clothes and making sure they are displayed neatly, either on hangers or folded on a shelf. It generally takes little effort to make clothes on hangers look neat; it takes much more effort to make stacks of folded clothes look neat.
Assume the following. Managers of apparel stores care both that individual salespeople sell clothes and undertake effort toward ensuring that their stores look neat. It is relatively easy for managers to keep track of the sales generated by individual salespeople. Because of this, it is feasible to reward salespeople with commissions. It is extremely difficult for them to develop measures of how neat displays look. It is so difficult, in fact, that it is impossible for them to directly reward salespeople on the basis of how well they maintain displays. While payment on commission indirectly provides salespeople incentives toward maintaining displays -- they sell more if their store looks nicer -- these indirect incentives are extremely weak, weak enough to be ignored completely. Any effort expended by salespeople toward maintaining displays primarily comes from their pride from working at a nice-looking store.
Hidayatallah (1997) surveys 37 retail apparel stores in the South Coast Mall, and finds the following. First, slightly over half of the stores pay their salespeople commissions. Second, there is a negative correlation between paying salespeople commissions and the fraction of clothes in the store that were displayed folded. That is, stores which displayed a high fraction of their clothes folded tended not to pay their salespeople commissions. In contrast, those which displayed most of their clothes on hangers tended to pay them commissions.
Applying Holmstrom and Milgrom theory, explain Hidayatallah's second finding.
Applying H&M directly, if it is impossible to directly reward display maintenance, the only way to encourage display maintenance would be to provide weaker incentives for everything else. Therefore, if effort toward display maintenance is more important at stores with folded clothes than at those with hung clothes, one would expect lower sales commissions at stores with folded clothes.
At some retail stores, "team-selling" is used. For example, different employees greet, serve, and ring out customers. Would you expect commissions to be more common at stores which "team- sell" than those at which single salespeople greet, serve, and ring out customers? Why or why not?
Commissions are not going to be particularly effective in stores with "team selling" because of free-rider effects. Individuals' compensation are going to be based a lot on factors outside of their control -- such as other team members' effort levels. Commissions may be more effective at stores where single salespeople greet, serve and ring out customers -- their sales are going to be a function of how they themselves treat customers. Factors outside of their control have less of an impact than where team selling is used. One would predict commissions to be more common at stores where team selling is not used.