Deck 10: Incentive Conflicts and Contracts

Question 1

ANALYZING MANAGERIAL DECISIONS: eBay.com
eBay operates the world's largest online auction. In early 2008, eBay operated in 39 counties with 276 million registered users worldwide. The total value of all successfully closed items in 2007 was $59 billion with an average of $2,039 worth of goods trading on the site every second. Sellers pay a small fee to eBay to list their items. They provide a description of the item, photographs, the minimum acceptable bid, accepted forms of payment, and other relevant information. Items can be sold at a fixed price or through an auction. In an auction, bidders submit electronic bids over the Internet. After the auction closes (auctions usually last several days), the high bidder receives an e-mail. The high bidder must contact the seller within three business days to claim the item and arrange payment and delivery. eBay provides other support services:
• The Feedback Forum is a place where eBay users leave comments about each other's buying and selling experiences. If you are a bidder, you can check the seller's Feedback Profile easily before you place a bid to learn about the other buyers' experience. If you're a seller, you can do the same thing to check out buyers. Each participant is given a Feedback Score based on the number of positive and negative ratings that they have received. Participants with sufficient positive ratings are flagged by colored stars. The highest rating is the "Red shooting star." eBay has created a set of policies to guard against "feedback manipulation" and "feedback abuse."
• eBay users are encouraged to settle transactions through PayPal. PayPal provides free insurance of up to $2,000 on some items to protect buyers in cases where they do not receive the item or it was less than expected.
• Participants sign user agreements that specify the trading rules and expectations. eBay's safety staff investigates alleged misuses at eBay such as fraud, trading offenses, and illegally listed items. Potential resolutions include such things as banning a person from future trading on eBay.
What are the contracting costs at eBay

Answer 1

The various contracting cost includes: -
• eBay has to incur expenses on searching potential sellers, bargaining costs, and various other costs on drafting and policing contracts between the seller and the management.
• Formulation of feedback forum and managing it efficiently also results in add on expenses for the company.
• eBay also provides insurance to its customers to protect them from contractual issues between the seller and buyers, thus further added contracting costs for the company.
Therefore, the company has to acquire numerous contracting costs for the smooth functioning of various parties involved.

Question 2

Name the two parties involved in an agency relationship.

Answer 2

Agency relationship:
The agency relationship is the form of business relationship where the principal hires an agent ot perform the duties. The principal gives the legal authority to an agent to act on behalf of the principal while dealing with a third party.
The agency relationship consists of the agreement in which one party engages another party, to perform some services on the behalf of the first party.
The parties involved in the agency relationship are:
1.
Principal:
The person on behalf of whom the business relationships are handled by the agent, he is the sole person who appoints the agents to carry on the tasks of the business.
2.
Agent:
The person who is given the responsibility to deal with the third party on behalf of the principal, he is the individual capable of understanding and carrying out the tasks assigned by the principal.

Question 3

ANALYZING MANAGERIAL DECISIONS: eBay.com
eBay operates the world's largest online auction. In early 2008, eBay operated in 39 counties with 276 million registered users worldwide. The total value of all successfully closed items in 2007 was $59 billion with an average of $2,039 worth of goods trading on the site every second. Sellers pay a small fee to eBay to list their items. They provide a description of the item, photographs, the minimum acceptable bid, accepted forms of payment, and other relevant information. Items can be sold at a fixed price or through an auction. In an auction, bidders submit electronic bids over the Internet. After the auction closes (auctions usually last several days), the high bidder receives an e-mail. The high bidder must contact the seller within three business days to claim the item and arrange payment and delivery. eBay provides other support services:
• The Feedback Forum is a place where eBay users leave comments about each other's buying and selling experiences. If you are a bidder, you can check the seller's Feedback Profile easily before you place a bid to learn about the other buyers' experience. If you're a seller, you can do the same thing to check out buyers. Each participant is given a Feedback Score based on the number of positive and negative ratings that they have received. Participants with sufficient positive ratings are flagged by colored stars. The highest rating is the "Red shooting star." eBay has created a set of policies to guard against "feedback manipulation" and "feedback abuse."
• eBay users are encouraged to settle transactions through PayPal. PayPal provides free insurance of up to $2,000 on some items to protect buyers in cases where they do not receive the item or it was less than expected.
• Participants sign user agreements that specify the trading rules and expectations. eBay's safety staff investigates alleged misuses at eBay such as fraud, trading offenses, and illegally listed items. Potential resolutions include such things as banning a person from future trading on eBay.
eBay claims that it has only a small problem with fraud and misuse of the system. Does this imply that it is overinvesting in addressing potential contracting problems Underinvesting Explain.

Answer 3

eBay incur huge expenses to make sure that there is fair dealing between the seller and buyer. It claims that over many years it has been able to minimize fraudulent activities. It can be said it may both overinvest and underinvest sometimes in addressing the contracting issues.
eBay has been in the market from the past many years. It is successfully penetrated in global markets. Viewing the success of the company over many years, the fact can be argued that the company might be overinvesting.
But on the other hand, the e-commerce industry is highly competitive. The entry of new companies and constant improvement in strategies by the existing pose a definite threat to the company. So, based on this argument it can be said the company might be underinvesting as there is continuous competition in the market.
Therefore, the argument that eBay is underinvesting or overinvesting on its contractual issues depends upon the business environment. If the company has a good public image it should invest until the point where its image remains intact, whereas if it faces enormous competition regular improvements and investing would be required.

Question 4

What potential problems exist in agency relationships

Question 5

Is it worthwhile for shareholders to seek to completely eliminate incentive problems with managers and directors through means such as monitoring Why or why not

Question 6

What is adverse selection Give an example.

Question 7

How do reputational concerns aid in the enforcement of contracts

Question 8

ANALYZING MANAGERIAL DECISIONS: Opening a New Restaurant
You are the owner of a small restaurant chain in the Portland, Oregon, area. All five of your restaurants employ the same basic business concept and have similar building designs, menus, and service formats. Each of the outlets has a head manager who has primary responsibility for the day-to-day operations at that location. All five of the outlets are within a 20-mile radius of your central office. You are actively involved in the business and frequently meet with your top management staff. You often spend time at the restaurants during business hours, visiting with customers and helping to manage the staff. You pay each of your managers $40,000 per year and provide them with a package of fringe benefits (e.g., paid vacation and insurance). Over the past three years you have also given each of the managers a $3,000 holiday bonus in December.
Several of your customers moved last year from Portland to Salt Lake City, Utah. They have e-mailed you suggesting that you open a restaurant in Salt Lake. They miss your food, service, and restaurant format. They believe the new restaurant would be successful. You have conducted market research and are thinking seriously about starting the new restaurant. One concern that you have is that Salt Lake is over 750 miles from Portland.
Discuss the incentive conflicts that are likely to arise between owners and managers of a restaurant.

Question 9

Schmidt Brewing Company is family-owned and -operated. The family wants to raise some capital by selling 30 percent of the common stock to outside shareholders. The company has been profitable and the family indicates that it expects to pay high dividends to shareholders. The family will maintain 70 percent ownership of the common stock and continue to manage the firm. The rights of shareholders are specified in the company's corporate charter. The charter specifies such items as voting rights (procedures and items subject to a vote), meeting requirements, board size, rights to cash flows, and so on. Once adopted, a charter can only be changed by a vote of the shareholders. What types of provisions in the corporate charter of Schmidt Brewing might motivate minority shareholders to pay higher prices for the stock Explain.

Question 10

ANALYZING MANAGERIAL DECISIONS: eBay.com
eBay operates the world's largest online auction. In early 2008, eBay operated in 39 counties with 276 million registered users worldwide. The total value of all successfully closed items in 2007 was $59 billion with an average of $2,039 worth of goods trading on the site every second. Sellers pay a small fee to eBay to list their items. They provide a description of the item, photographs, the minimum acceptable bid, accepted forms of payment, and other relevant information. Items can be sold at a fixed price or through an auction. In an auction, bidders submit electronic bids over the Internet. After the auction closes (auctions usually last several days), the high bidder receives an e-mail. The high bidder must contact the seller within three business days to claim the item and arrange payment and delivery. eBay provides other support services:
• The Feedback Forum is a place where eBay users leave comments about each other's buying and selling experiences. If you are a bidder, you can check the seller's Feedback Profile easily before you place a bid to learn about the other buyers' experience. If you're a seller, you can do the same thing to check out buyers. Each participant is given a Feedback Score based on the number of positive and negative ratings that they have received. Participants with sufficient positive ratings are flagged by colored stars. The highest rating is the "Red shooting star." eBay has created a set of policies to guard against "feedback manipulation" and "feedback abuse."
• eBay users are encouraged to settle transactions through PayPal. PayPal provides free insurance of up to $2,000 on some items to protect buyers in cases where they do not receive the item or it was less than expected.
• Participants sign user agreements that specify the trading rules and expectations. eBay's safety staff investigates alleged misuses at eBay such as fraud, trading offenses, and illegally listed items. Potential resolutions include such things as banning a person from future trading on eBay.
How does eBay create value

Question 11

Which of the following examples is an adverse-selection problem and which is an incentive problem Explain why. In each case, give one method that the restaurant might use to reduce the problem.
a. A restaurant decides to offer an all-you-can-eat buffet that is sold for a fixed price. The restaurant discovers that the customers for this buffet are not its usual clientele. Instead, the customers tend to have big appetites. The restaurant loses money on the buffet

Question 12

What is a firm

Question 13

In 1992 the state of California charged Sears Auto Centers with overcharging customers for unneeded or unperformed repairs. Sears agreed to a settlement that could cost as much as $20 million. Sears had compensated its salespeople with commissions based on total sales. Following the settlement, Sears dropped the commissions and went to a straight salary. Sears recently indicated that it is planning to reinstate commissions for salespeople in their Auto Centers. It even plans on paying commissions for selling customers brake jobs and wheel alignments. These two products were the core of the 1992 scandal. Sears says that it has taken steps to prevent a recurrence of past problems. In particular, the decision right to recommend repairs is granted to mechanics who are paid a straight salary. Sales consultants are paid commissions for selling repair services but are not authorized to recommend repairs. Under the old system that caused problems, these individuals diagnosed repair problems and sold the corresponding service to customers. Why do you think Sears wants to reinstall commissions for its salespeople Do you think that the new safeguard that separates diagnosing problems from selling services will prevent a recurrence of past problems Explain.

Question 14

ANALYZING MANAGERIAL DECISIONS: Opening a New Restaurant
You are the owner of a small restaurant chain in the Portland, Oregon, area. All five of your restaurants employ the same basic business concept and have similar building designs, menus, and service formats. Each of the outlets has a head manager who has primary responsibility for the day-to-day operations at that location. All five of the outlets are within a 20-mile radius of your central office. You are actively involved in the business and frequently meet with your top management staff. You often spend time at the restaurants during business hours, visiting with customers and helping to manage the staff. You pay each of your managers $40,000 per year and provide them with a package of fringe benefits (e.g., paid vacation and insurance). Over the past three years you have also given each of the managers a $3,000 holiday bonus in December.
Several of your customers moved last year from Portland to Salt Lake City, Utah. They have e-mailed you suggesting that you open a restaurant in Salt Lake. They miss your food, service, and restaurant format. They believe the new restaurant would be successful. You have conducted market research and are thinking seriously about starting the new restaurant. One concern that you have is that Salt Lake is over 750 miles from Portland.
You have been able to control these conflicts relatively well at your existing restaurants. Do you anticipate that the conflicts will be easier or harder to control at the new Salt Lake location

Question 15

The Sonjan company currently purchases health insurance for all of its 1,000 employees. The company is considering adopting a flexible plan whereby employees either can have $2,000 in cash or purchase an insurance policy (which currently costs $1,000). Do you see any potential problems with the new plan Explain.

Question 16

ANALYZING MANAGERIAL DECISIONS: eBay.com
eBay operates the world's largest online auction. In early 2008, eBay operated in 39 counties with 276 million registered users worldwide. The total value of all successfully closed items in 2007 was $59 billion with an average of $2,039 worth of goods trading on the site every second. Sellers pay a small fee to eBay to list their items. They provide a description of the item, photographs, the minimum acceptable bid, accepted forms of payment, and other relevant information. Items can be sold at a fixed price or through an auction. In an auction, bidders submit electronic bids over the Internet. After the auction closes (auctions usually last several days), the high bidder receives an e-mail. The high bidder must contact the seller within three business days to claim the item and arrange payment and delivery. eBay provides other support services:
• The Feedback Forum is a place where eBay users leave comments about each other's buying and selling experiences. If you are a bidder, you can check the seller's Feedback Profile easily before you place a bid to learn about the other buyers' experience. If you're a seller, you can do the same thing to check out buyers. Each participant is given a Feedback Score based on the number of positive and negative ratings that they have received. Participants with sufficient positive ratings are flagged by colored stars. The highest rating is the "Red shooting star." eBay has created a set of policies to guard against "feedback manipulation" and "feedback abuse."
• eBay users are encouraged to settle transactions through PayPal. PayPal provides free insurance of up to $2,000 on some items to protect buyers in cases where they do not receive the item or it was less than expected.
• Participants sign user agreements that specify the trading rules and expectations. eBay's safety staff investigates alleged misuses at eBay such as fraud, trading offenses, and illegally listed items. Potential resolutions include such things as banning a person from future trading on eBay.
What potential contracting problems exist on eBay

Question 17

Give examples of incentive conflicts:
a. Between shareholders and managers.

Question 18

ANALYZING MANAGERIAL DECISIONS: Opening a New Restaurant
You are the owner of a small restaurant chain in the Portland, Oregon, area. All five of your restaurants employ the same basic business concept and have similar building designs, menus, and service formats. Each of the outlets has a head manager who has primary responsibility for the day-to-day operations at that location. All five of the outlets are within a 20-mile radius of your central office. You are actively involved in the business and frequently meet with your top management staff. You often spend time at the restaurants during business hours, visiting with customers and helping to manage the staff. You pay each of your managers $40,000 per year and provide them with a package of fringe benefits (e.g., paid vacation and insurance). Over the past three years you have also given each of the managers a $3,000 holiday bonus in December.
Several of your customers moved last year from Portland to Salt Lake City, Utah. They have e-mailed you suggesting that you open a restaurant in Salt Lake. They miss your food, service, and restaurant format. They believe the new restaurant would be successful. You have conducted market research and are thinking seriously about starting the new restaurant. One concern that you have is that Salt Lake is over 750 miles from Portland.
Should you offer the new head manager at the Salt Lake location the same compensation contract that you are using for the five managers in Portland

Question 19

ANALYZING MANAGERIAL DECISIONS: eBay.com
eBay operates the world's largest online auction. In early 2008, eBay operated in 39 counties with 276 million registered users worldwide. The total value of all successfully closed items in 2007 was $59 billion with an average of $2,039 worth of goods trading on the site every second. Sellers pay a small fee to eBay to list their items. They provide a description of the item, photographs, the minimum acceptable bid, accepted forms of payment, and other relevant information. Items can be sold at a fixed price or through an auction. In an auction, bidders submit electronic bids over the Internet. After the auction closes (auctions usually last several days), the high bidder receives an e-mail. The high bidder must contact the seller within three business days to claim the item and arrange payment and delivery. eBay provides other support services:
• The Feedback Forum is a place where eBay users leave comments about each other's buying and selling experiences. If you are a bidder, you can check the seller's Feedback Profile easily before you place a bid to learn about the other buyers' experience. If you're a seller, you can do the same thing to check out buyers. Each participant is given a Feedback Score based on the number of positive and negative ratings that they have received. Participants with sufficient positive ratings are flagged by colored stars. The highest rating is the "Red shooting star." eBay has created a set of policies to guard against "feedback manipulation" and "feedback abuse."
• eBay users are encouraged to settle transactions through PayPal. PayPal provides free insurance of up to $2,000 on some items to protect buyers in cases where they do not receive the item or it was less than expected.
• Participants sign user agreements that specify the trading rules and expectations. eBay's safety staff investigates alleged misuses at eBay such as fraud, trading offenses, and illegally listed items. Potential resolutions include such things as banning a person from future trading on eBay.
How does eBay address these problems

Question 20

What is asymmetric information How can it limit contracts from solving incentive conflicts