1. Chapter 21
Main Points
· Principals want agents to work for their (the principals’) best
interests, but agents typically have different goals than do
principals. This is called incentive conflict.
· Incentive conflict leads to moral hazard and adverse selection
problems when agents have better information than principals.
· Three approaches to controlling incentive conflict areIn a
well-run organization, decision makers have (1) the information
necessary to make good decisions and (2) the incentive to do so.
· Fixed payment and monitoring (shirking, adverse selection,
and monitoring costs),
· Incentive pay and no monitoring (must compensate agents for
bearing risk), or
· Sharing contracts and some monitoring (some shirking and
some risk compensation).
· If you decentralize decision-making authority, you should
strengthen incentive compensation schemes.
· If you centralize decision-making authority, you should make
sure to transfer needed information to the decision makers.
· To analyze principal–agent conflicts, focus on three questions:
· Who is making the (bad) decisions?
· Does the employee have enough information to make good
decisions?
· Does the employee have the incentive to make good decisions?
· Alternatives for controlling principal–agent conflicts center on
one of the following:
· Reassigning decision rights
· Transferring information
· Changing incentives
The Principal-Agent Problem
The last three chapters that we will discuss revolve around the
Principal-Agent Problem. In the principal-agent problem, there
is one entity, the principal, who wishes to have someone else,

2. the agent, perform some actions for him. The problems
associated with the principal-agent relationship arise from the
fact that the principal and agent have different incentives. Thus,
the principle may wish the agent to take some action but it is in
the agent’s best interest to perform some other action. We will
study situations in which the principal-agent problem arises and
examine potential solutions to the problem. In this chapter the
agents will be employees and the agents are either their direct
supervisors, higher-level managers or the owners or
shareholders of the company. In Chapter 22, the agent will be a
division of the firm, and in Chapter 23 the agent will be a
vertically-related but separate business.
Principle-Agent Relationships in Firms
Stockholders and owners have one goal for the firm:
maximizing profits. They want everyone associated with the
firm to make decisions with a focus solely on the profit of the
firm. The CEO and board members likely share the desire for
the firm’s profitability, perhaps through incentives in their
contracts, but the board and CEO have additional motivations
beyond the firm’s profitability. Among their motivations may be
keeping their jobs, accumulating power, and accumulating the
trappings of the position. This may cause the CEO to make sub-
optimal decisions as far as the stockholders are concerned.
Further down the chain are managers of divisions, stores or
other subsections of the company. They may be focused on
profitability, but perhaps only as it relates to decisions under
their purview. Managers also may be motivated by the desire for
promotions and other incentives and may make decisions that
are not in the shareholder’s or upper management’s best
interests. Employees have vastly different incentives – the
salesperson on the floor, the cashier at the register, or the cook
in the kitchen probably do not give one second’s thought to the
profitability of the firm. Rather, they care about keeping their
jobs, getting promotions, and the amount of pay and other non-
pecuniary benefits they receive.
Thus, it should not be surprising that absent a well-designed

3. incentive and evaluation system, employees may take an action
or make a decision for which a principal would have desired a
different action or decision.
Fixing a Broken Principal-Agent Relationship:
A good structure to eliminate the principle agent problem is
based on aligning decision rights with the information the
decision maker has, incentivizing the decision maker to ensure
the desired decision, and effectively evaluating the decision
maker’s performance. If there is a problem, the book suggests
the following checklist:
1. Who is making the (bad) decision?
2. Does the decision maker have enough information to make a
good decision?
3. Does the decision maker have the incentive to do so – that is,
how is the decision maker evaluated and compensated?
Note that the first item identifies the decision maker, and the
second item asks if the decision maker has the appropriate
information to make the correct decision. If not, the lack of
sufficient information must be fixed. If the decision maker has
enough information to make a correct decision but instead
makes a bad decision, then the problem likely lies in the
decision maker’s incentives or how they are evaluated. When
one of the aspects of the agent’s environment is changed, the
others most likely need to be adjusted as well. That is, if the
decision maker did not have sufficient information to make the
correct decision then one solution would be to give the
decision-making authority to someone else who has the
information. If this leads to decentralization, where decisions
are made by lower-level employees, the new decision-maker’s
incentives and evaluation process must be adjusted to align the
principal’s goals and those of the decision-maker. As the book
states, when decision-making is decentralized, “you should also
strengthen incentive compensation schemes.” If decision-
making is centralized, then incentives must be designed to
transfer information truthfully and accurately to the decision
maker. Alternatively, if you increase an agent’s incentives but

4. do not give them decision-making authority, the incentives will
do nothing since the agent cannot respond to the incentives.
So how should broken principal-agent relationships be repaired?
The answer is that it depends. There are numerous approaches
to changing decision rights, incentives, and evaluation systems,
and they all have their strengths and weaknesses. What is the
most appropriate in one situation may not be good in another.
The book gives several examples but the underlying thread in
all the solutions is that the decision maker must have incentives
that align the agent’s desires with the principal’s.
Chapter 22
Main Points
· Companies are principals trying to get their divisions (agents)
to work profitably in the interests of the parent company.
· Transfer pricing does not merely transfer profit from one
division to another; it can result in moving assets to lower-value
uses. Efficient transfer prices are set equal to the opportunity
cost of the asset being transferred.
· A profit center on top of another profit center can result in too
few goods being sold; one common way of addressing this
problem is to change one of the profit centers into a cost center.
This eliminates the incentive conflict (about price) between the
divisions.
· Companies with functional divisions share functional expertise
within a division and can more easily evaluate and reward
division employees. However, change is costly, and senior
management must coordinate the activities of the various
divisions to ensure they work towards a common goal.
· Process teams are built around a multi-function task and are
evaluated based on the success of the project on which they are
working.
· When divisions are rewarded for reaching a budget threshold,
they have an incentive to lie to make the threshold as low as
possible, thus ensuring they get their bonuses. In addition, they
will pull sales into the present, and push costs into the future, to
make sure they reach the threshold. A simple linear

5. compensation scheme solves this problem.
The Principal-Agent Problem Redux
In Chapter 21 we discussed the Principal-Agent problem as it
related to employees. In this chapter, we examine the
relationship between the firm and divisions within the firm. One
division of the firm may not directly care about the overall
profit of the firm and thus it could make decisions not in the
firm’s best interest. The same checklist used to identify the
problem when an employee is an agent can be used to identify
the problem with a division as the agent.
Structures of Organizations: Cost Centers and Profit Centers
To understand the incentives of divisions, one must first know
how they are evaluated. A division of a firm that acts as a profit
center is evaluated on the profit generated by that division. The
profit generated by a division is calculated as if it were a firm
on its own: the costs of the division are subtracted from the
revenues of the firm, and the money left over is the profit of the
division. To ensure that a profit center is run as it is intended,
with profit as the only goal, the manager of the division should
be rewarded based on the profit of the division. In this way the
firm’s desires to have the division run as a profit center align
with the agent responsible for making decisions for the
division. A division of a firm can also be a cost center. A cost
center is evaluated on the costs required to generate output.
Like the profit center, the manager of a cost center should be
rewarded based on the division’s mission. In this case, the
manager’s incentives should be tied to keeping costs low.
Incentive Conflicts and Transfer Pricing
Conflict can arise if two profit centers inside a company
transact with each other. When one division sends an
intermediate product to another division, the division receiving
the product must pay the other division some price for receiving
the good. Since the price represents a cost for one division and
a revenue for the other division, one division would want a high
price and the other division would want a low price. If the
transfer price – the price charged to one division – is set by an

6. entity inside the company, tension can arise. The two divisions
may incur completely avoidable costs by lobbying the price-
setter for a more favorable price. One way to avoid the lobbying
and tension is to use market prices, since market prices reveal
the true value of the particular good.
Another solution that the book discusses is to turn the supplier
of the intermediate good into a cost center. In that event, the
division supplying the good no longer cares what price it
receives for the good since the revenue does not affect its costs.
If the transfer price is the marginal cost to produce the
intermediate good, then the profit center will act in the firm’s
best interest, since its marginal costs of production are the same
as the firm’s marginal cost of production. However, as
described below, if one division is changed from a profit center
to a cost center, care must be taken so that the new cost center
continues to operate in the firm’s best interest. Its incentives
and evaluation process must be changed to completely align
with the new status of the division.
Pitfalls of Compensation Schemes
As with solutions to the Principle-Agent problem when the
agent is an employee, the solutions to the problem when the
agent is a division of the firm usually have costs in addition to
the benefits of ‘solving’ the principal-agent problem. As the
text describes, if there is tension between two divisions that are
profit centers, turning one division into a cost center will
alleviate the tension between the two divisions, but now the new
cost center faces new incentives since its goal has been changed
to minimize costs. That may change some of the division’s
decisions, perhaps to use inferior raw materials which will lead
to an inferior finished product which may not be in the firm’s
best interest. As with changes to the employee’s environment,
when making changes to the environment of a division care
must be taken to make sure that the decision rights, incentives,
and evaluation system remain aligned.
Chapter 23
Main Points

7. · Do not purchase a customer or supplier merely because that
customer or supplier is profitable. There must be a synergy that
makes them more valuable to you than they are to their current
owners. And do not overpay.
· If unrealized profit exists at one stage of the vertical supply
chain – as often happens when regulations limit profit – a firm
can capture some of the unrealized profit by vertical
integration, by tying, by bundling, or by excluding competitors.
· The double-markup problem occurs when complementary
products compete with one another. Setting prices jointly
eliminates the double-markup problem and is often a motive for
vertical integration or maximum price contracts between a
manufacturer and retailer.
· Restrictions on intra-brand competition like minimum resale
price maintenance or exclusive territories provide retailers with
higher profit, giving them incentives to provide demand-
enhancing services to customers.
· If a product has two retail uses, a manufacturer may find it
profitable to integrate downstream so that the firm can capture
the profit through price discrimination. Vertical integration
stops arbitrage between the two products, which allows price
discrimination.
· Outsource an activity if the outsourcer can perform the
activity better or more cheaply than you can.
The Principal-Agent Problem Redux, Part II
The principal-agent problem can also apply to separate
businesses in the same vertical supply chain. A manufacturer
typically uses a retailer to deliver its product to the consumer.
The aims and goals of the retailer are not the same as the
manufacturer. The retailer is concerned with its profit, which is
not (strongly) influenced by the particular product that it sells.
However, the manufacturer’s profit strongly depends on which
product the retailer sells. For instance, a grocery store likely
makes a similar profit by selling a two-liter bottle of Coca-Cola
as it does by selling a two-liter bottle of Pepsi. Thus, there is no
incentive for the grocer to promote one product over the other.

8. However, Coca-Cola (or Pepsi) most definitely would want their
product promoted over their competitors. In this case, the
retailer is acting as the manufacturer’s agent. Solving, or
attempting to solve, the principal-agent problem in this
situation is more difficult than in the situations in the previous
two chapters; if the agent is employed by the firm, then the firm
can simply set the terms of employment to set up decision-
making rights, incentives and the evaluation system to align the
agent’s incentives with the firm’s incentives. In this case, the
principal cannot dictate terms to the agent. Other methods, some
of which are described in the text, must be used to align the
agent’s incentives with the principal’s.
I will let the chapter cover the remainder of the material, as it is
mostly applying concepts from the previous two chapters to the
relationship between two separate firms in a vertical supply
chain.
Thinking and Language Reflection Worksheet
Name:
Reflect on your understanding of the relationship between
thinking and language.
Answer the following questions in 100-200 words each:
a) How do individuals acquire and develop language?
b) How do you personally communicate your thoughts and how
did you learn to do so?
c) Based on your own experiences, what are some symbols (e.g.,

9. letters of the alphabet) people use to communicate?
d) Explain how you think these symbols are related to critical
thinking?
The assignment will be graded according to the following
criteria:
a) Clarity: The intent of the writer is clear.
b) Logic: The answer makes sense.
c) Answers question: The questions are addressed fully.
d) Mechanics: Answers contain proper punctuation and
grammar.