6-1  Introduction

[6.2 Asymmetric Information and Signalling] 

[6.3 Incentives and Compensation]  

[6.4 The Hold-Up Problem]

 

Background

 

What happens when sellers possess superior information to buyers regarding the quality of their products? What happens when it is hard to monitor the effort individuals expend in undertaking productive activities? What happens when it is difficult to write contracts to cover all eventualities? These are real issues facing decision-makers in business that lead to many market and organisational phenomena.

 

This segment will introduce you to the economics of information. It will do so by focussing on the employment relationship. How can firms use screening and employees use signalling to overcome informational problems? Can employers devise pay-for-performance contracts with superior incentives? What are the costs of stronger incentives for employees? What happens when it is simply not possible to use a contract to achieve desirable outcomes? An awareness of these issues is critical for any effective manager.

 

Segment Overview

 

This segment covers the following topics:

  • Topic 6.2, “Asymmetric Information and Signalling”, provides an introduction to the impact of asymmetric information on economic activities. It includes the well-known lemons problem as well as how signalling can be used to alleviate informational problems.

  • Topic 6.3, “Incentives and Compensation”, provides an introduction to formulating incentives to encourage individual effort. It demonstrates the importance of output-based pay as well as the risks associated with various incentive contracts.

  • Topic 6.4, “Contractual Incompleteness”, describes situations where firms might be subject to ‘hold-up’; that is, threats of contract renegotiation after key investments and costs have been incurred.

As your assignment for this segment, you will be required to evaluate a pay-for-performance plan.

 

Your Learning Outcomes

 

Upon completing this segment, you should be able to

  • explain thoroughly how market imperfections arise from asymmetric information

  • identify the key issues and trade-offs in setting incentives to motivate employees

  • identify issues of contractual incompleteness that might lead to the hold-up problem

 

Sources

 The materials presented here draw upon teaching materials prepared by Edward Lazear (Stanford University), Michael Gibbs (University of Chicago) and Joshua Gans (University of Melbourne).

 

 

You may now proceed to topic 6.2, “Asymmetric Information and Signalling”.