Stefan Reichelstein

Investment Decisions and Managerial Performance Evaluation

This paper considers incentive provisions for a manager who makes investment decisions. The managers performance measure can be based on current accounting information: cash flow, depreciation, book value, and current investment. We argue that Residual Income is the unique (linear) performance measure that achieves goal congruence, i.e., the manager accepts all positive NPV projects, and only those. If the manager has the same discount rate as the owner, the depreciation rules remain indeterminate. However, if the managers discount rate assumes potentially a whole range of values, then a particular depreciation policy combined with Residual Income is the unique way to achieve goal congruence.

Dominant Strategy Implementation of Bayesian incentive Compatible Allocation Rules

Abstract A large literature on incentive mechanisms represents incentive constraints by the requirement that truthful reporting be a Bayesian equilibrium. This paper identifies mechanism design problems for which there is no loss in replacing Bayesian incentive compatibility by the stronger requirement of dominant strategies. We identify contexts where it is possible to change the transfer payments of an optimal Bayesian mechanism so as to create dominant strategies and yet leave every participants expected utility unchanged. We also address the issue of multiple equilibria and unique implementation. Contexts where these results apply include auctions, bilateral bargaining, procurement contracting, and intrafirm resource allocation.

A theory of responsibility centers

Abstract We consider a principal-agent model to examine the effectiveness of responsibility centers, in particular cost or profit centers. We show that rather than contracting with each agent directly, the principal can create equally powerful incentives by setting up a responsibility center structure. The principal contracts with only the ‘manager’ of the center and delegates contracting with other agents and coordinating their activities. The principal then must monitor some measure of financial performance such as the centers cost of profit. We also find that responsibility centers dominate direct contracting with the agents when communication is limited.

The Prospects for Cost Competitive Solar PV Power

New solar Photovoltaic (PV) installations have grown globally at a rapid pace in recent years. We provide a comprehensive assessment of the cost competitiveness of this electric power source. Based on data available for the second half of 2011, we conclude that utility-scale PV installations are not yet cost competitive with fossil fuel power plants. In contrast, commercial-scale installations have already attained cost parity in the sense that the generating cost of power from solar PV is comparable to the retail electricity prices that commercial users pay, at least in certain parts of the U.S. This conclusion is shown to depend crucially on both the current federal tax subsidies for solar power and an ideal geographic location for the solar installation. Projecting recent industry trends into the future, we estimate that utility-scale solar PV facilities are on track to become cost competitive by the end of this decade. Furthermore, commercial-scale installations could reach “grid parity” in about ten years, if the current federal tax incentives for solar power were to expire at that point.

Value of communication in agencies

Abstract Focusing on an agency model in which the agent receives private information prior to contracting, we analyze whether the principal benefits from offering the agent a menu of contracts. We show that, under certain conditions, the constraints imposed by the self-selection requirement are so restrictive that a menu of contracts has no value, i.e., the principal might as well offer a single contract based only on some jointly observed outcome. Conversely, we identify cases where a menu of contracts is valuable because it allows the principal to implement a more efficient incentive structure.

Centralization Versus Delegation and the Value of Communication

Management literature has long debated the comparative advantages of centralized versus decentralized decision making. The usual framework of analysis focuses on an organization that consists of a principal (central management, headquarters) and one or several agents (local managers, divisions). Centralization, it is argued, allows the principal to retain control over important decisions. On the other hand, relevant information is generally dispersed among the members of the organization. To exploit the relevant information for decision making the principal must either elicit information or delegate decision making. Delegation has not played a prominent role in the work on incentive mechanisms. For the most part, this work has focused on revelation mechanisms in which all agents communicate their information to the principal who then makes all the decisions. The Revelation Principle asserts that the maximum performance attainable by some incentive mechanism can be replicated by a revelation mechanism. In particular, any mechanism involving delegation of decision making can, without loss of performance, be replaced by a completely centralized mechanism. The reasoning of the Revelation Principle, however, is valid only in a world of unlimited and costless communication. Firms decentralize, as the management literature points out (see, for example, Kaplan [1982]), precisely because communication is costly and managers have limited abilities to communicate and to process information. These costs and limitations seem essential to explaining the creation of organizational

Negotiated versus Cost-Based Transfer Pricing

This paper studies an incomplete contracting model to compare the effectiveness of alternative transfer pricing mechanisms. Transfer pricing serves the dual purpose of guiding intracompany transfers and providing incentives for upfront investments at the divisional level. When transfer prices are determined through negotiation, divisional managers will have insufficient investment incentives due to “hold-up” problems. While cost-based transfer pricing can avoid such “hold-ups”, it does suffer from distortions in intracompany transfers. Our analysis shows that negotiation frequently performs better than a cost-based pricing system, though we identify circumstances under which cost-based transfer pricing emerges as the superior alternative.

Controlling Investment Decisions: Depreciation- and Capital Charges

This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and to base the managers compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the managers investment incentives.

Participation, Slack, And Budget-Based Performance Evaluation

In this paper we discuss a class of budget-based performance evaluation schemes with the desirable feature that they induce an informed manager to set unbiased standards. We show that these schemes are frequently optimal incentive contracts in the presence of moral hazard, and we find that they retain their incentive properties in the presence of several competing managers. For concreteness, our analysis focuses on the problem faced by headquarters (HQ) in evaluating the performance of a cost center manager. In the simplest form of the budget-based schemes, compensation can be expressed as the sum of two terms. The first depends only on a cost estimate (standard) issued by the manager and the second term consists of the difference between estimated and actual cost, multiplied by a proportionality factor which varies with the estimated cost. A budgetbased compensation scheme can then be viewed as a menu of linear compensation functions, each corresponding to a different cost estimate submitted by the manager. In previous work, Ijiri, Kinard, and Putney [1968] discuss an evaluation system based on estimated and actual performance. However, they do not explicitly model preferences, information asymmetries, or moral hazard, and therefore they cannot model the behavior induced by their proposed evaluation scheme or compare alternative evaluation schemes. In reference to a proposed Soviet incentive scheme, Weitzman [1976]

Game Forms with Minimal Message Spaces

This paper is concerned with the amount of communication that must be provided to implement a performance standard by a mechanism whose stationary messages have the Nash property. In p articular, the authors study implementation of Walrasian allocations in exchange environments. They show that the smallest message space t hat implements Walrasian allo-cations is one of dimension, roughly, n E (. 1 1)& ./(n 1 1), where . is the number of commodities and n the number of agents. The authors exhibit an implementing mechanism whos e message space has that dimension. Copyright 1988 by The Econometric Society.