Assignment Prompt & Instructions
– ## EconomicsforManagersECO6301UnitVIIIFinalProject.docx
– ## UnitVIIStudyGuide.pdf
– ## UnitVIIIStudyGuide.pdf
**## EconomicsforManagersECO6301UnitVIIIFinalProject.docx**
2
Economics for Managers ECO 6301
**Unit VIII Final Project**
This assignment measures your mastery of CLOs 1, 2, 3, 4, 5, and 6 and ULOs 7.3 and 7.4
**A Case Analysis of AMC**
**Assignment objective:** AMC is the largest movie theater operator in the world. AMC recently became a popular meme stock. Take a few minutes to learn more about
AMC Theaters. https://www.amctheatres.com/
**Length:** Your submission is required to be at least 5 pages in length and not more than 7 pages, not including the title page and references.
**References:** A minimum of 3 peer-reviewed references are required, any additional resources used are required to be scholarly/academic in nature and found in the CSU Library. APA formatting is required to be used for citations and references. Use this definition to define the term in the instructions.
**Definitions:** Scholarly journals are sometimes called academic journals. The terms are often used interchangeably to describe the same type of publication. These types of publications are published by universities, academic institutions, professional associations, and commercial enterprises and are compiled by scholars, academics, and other subject authorities.
**Details:** In your paper, include the following:
· Introduction
· Analyze the market before the COVID-19 pandemic. Describe how the pandemic affected the movie theater industry.
· Explain price discrimination in the movie theater market.
· Movie theater employees are generally paid hourly. Design an incentive pay structure for AMC Theaters and explain how it would work.
· Apply the concepts of economies of scale and economies of scope to AMC Theater's business model
· Apply the concepts of game theory to short selling and meme stocks as it relates to AMC Theaters
· Assess AMC Theater's potential for international expansion and potential trade policy issues.
· Explain the asymmetric information issues that lead to short selling and meme stocks.
· Apply the concepts of moral hazard to short selling and meme stocks, using AMC as an example.
· Conclusion
**## UnitVIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VII
At the end of this unit, you should be able to:
7. Explain the implications of uncertainty in managerial decision-making.
7.3 Compare moral hazard and adverse selection.
Required Unit Resources
Chapter 19: The Problem of Adverse Selection (ULO 7.3)
Chapter 20: The Problem of Moral Hazard (ULO 7.3)
Unit Lesson
Lesson: Adverse Selection and Moral Hazard (ULO 7.3)
This lesson introduces you to the topics covered in this unit: adverse selection and moral hazard.
Problems of uncertainty and incomplete information can create a variety of problems for business decision-
making. Two of those problems, adverse selection and moral hazard, will be the topics of this lesson. They
are both types of information asymmetries, where one party to an interaction has more information than the
other party.
Adverse Selection
Adverse selection occurs when one party is better informed about product quality than the other party. This
information difference specifically leads people to self-select in or out of a particular group, leading to
potentially problematic outcomes. To see these outcomes, consider the example of insurance.
Insurance is intended to cover people when something unexpected happens. People pay into a pool of money
(managed by an insurance company) and are then paid out if events covered by their insurance happen. You
likely have experience with health insurance, car insurance, and life insurance. The model works if there are
more people paying into the pool than drawing from the pool. People benefit from insurance if an unexpected
event happens to them and people lose if an event does not happen to them; although, there is still benefit
from security against risk even if the event does not happen. Ultimately, insurance works because people
tend to be risk-averse.
Recall the coin-flipping example from Unit VI. Since the expected value of the game is $0, a risk-neutral
person is completely indifferent to playing the game because they will expect to win nothing and lose nothing.
A risk-averse person would not want to participate in the coin-flipping activity because they have a greater
fear of losing than hope of winning a dollar. A risk-seeking person puts more weight on the positive outcome
from a risk so they would be more likely to engage in the coin-flipping activity.
You might see the potential adverse selection problem with insurance. People with a low probability of the
event happening to them are less likely to join the insurance pool while people with a high probability of the
event happening to them are more likely to join the insurance pool. This happens when young, healthy people
opt not to buy health insurance. It is why life insurance companies market to young people to buy insurance
now (that is, buy it when they likely do not need it). A pool of people made up primarily of people likely to use
insurance will put the insurance company out of business.
UNIT VII STUDY GUIDE
Adverse Selection and Moral Hazard
ECO 6301, Economics for Managers 2
UNIT x STUDY GUIDE
Title
Consider other types of insurance and how well they work. Who is likely to buy vision insurance? Most likely
people who already need glasses. As a result, there is not a very good cost-benefit to the consumer for vision
insurance. That is, the amount consumers pay in premiums is close to the maximum benefit they can get from
their insurance each year.
Protections Against Adverse Selection
As a consumer, the best way to deal with adverse selection is to recognize when it will likely happen, which
group you are likely to be in, and make your decisions accordingly. If you have perfect vision, for example,
there is not a need to get vision insurance. Consumer perception of adverse selection can also be
problematic for companies. In the market for used cars, consumers might believe that the only reason
somebody would look to sell their used car is if something is wrong with it. That is, consumers view the
market for used cars as an adverse selection problem. Given those assumptions, consumers would decrease
the amount they are willing to pay for a used car. So how can companies overcome these consumer
perceptions and consumer selection problems?
One way companies can overcome adverse selection is by screening consumers. Life insurance companies
screen prospective customers by asking for medical history. Car insurance companies consider past driving
record, age, gender, and marital status in setting premiums (or even if they will offer insurance) for customers.
Going back to the used car market, consumers can request a mechanic review of a car to screen bad cars
(or, to overcome the problem on their end, the seller offers certification of the car passing an inspection).
Another way to overcome the adverse selection problem is with signaling. Signaling occurs when one party
attempts to reveal information about themselves that other parties cannot duplicate. Education, for example,
is part signal. Getting a degree is a signal to potential employers of a certain level of competence and
problem-solving ability. People without the same level of competence and problem solving would not, the
thinking goes, be able to earn the degree. From the business perspective, advertising and branding can serve
as signals. Businesses would not bother to spend the money on advertising unless their product was worth
advertising. Similarly, established brand names send a signal to consumers that there is a reason the brand
has been established. Whether the brand is for low cost or for high quality, consumers can feel comfortable
knowing the brand will be as expected.
Adverse selection can happen in areas other than insurance. It can be particularly important for data analysis.
Imagine you need to figure out how much interest there is in a new product or service and you decide to
survey people to get your data. You go to the mall and ask people if they would like to participate in your
survey. Because you can only survey people who are willing to take your survey, you will only get responses
from people who opt to give up some of their shopping time to take your survey. Who might this be? It might
be mostly people who are just out for leisurely entertainment and do not have anything better to do. People
who have a high value for their time naturally opt out of taking your survey, and your data will not include
information on those types of people. That is, your survey will be biased.
Moral Hazard
Another type of asymmetry is moral hazard. One quick point on moral hazard is that it does not really have
anything to do with morals. Students sometimes fixate on the word moral and assume it has to do with people
acting immorally. It does not. Some may view the actions in a moral hazard as immoral, but moral hazard still
refers to specific incentives and actions, not morality generally.
Moral hazard occurs when one party does not bear the risks for the actions they take. Turning back to
insurance, a person with health insurance might be more likely to engage in risky activity knowing they will not
have to pay all of their medical bills. With car insurance, a driver might be less careful on the road knowing
their car would be replaced by the insurance company if they got into an accident.
Moral hazard and adverse selection can often explain similar events but the explanations are different.
Adverse selection would suggest that risky drivers would be more likely to buy cars with airbags. Moral
hazard would suggest that because a car has air bags, drivers are likely to take more risks when driving.
Ultimately, the difference is that adverse selection is about hidden information while moral hazard is about
hidden actions.
ECO 6301, Economics for Managers 3
UNIT x STUDY GUIDE
Title
Another type of moral hazard is when firms hire workers, but monitoring their behavior is either difficult or
costly. Without monitoring, employees can shirk in their job duties without repercussions. Potential shirking is
one reason to pay salespeople commission. Salespeople who shirk and do not make sales will not earn much
income. Shirking costs both the firm and the employee money as firms have less desire to pay workers in fear
they will shirk or have less money to pay workers because they have to pay for monitoring. Shirking leads into
the principal-agent problem, which will be covered in Unit VIII.
Moral hazard also played an important role in the 2008 financial crisis. Lending money already involves some
moral hazard. Borrowers engage in riskier activity with someone else’s money than they are willing to engage
in with their own money (the borrower, after all, is not risking their own money when they make a big
purchase, they are only risking a future promise to pay the money; a promise they can break). In the financial
crisis, however, banks were bailed out for their risky decisions in a variety of ways. First, their loans were
often insured by Fannie Mae and Freddie Mac. Second, many mortgage companies would write the loan and
then sell the loan so they were not the ones actually servicing the loan. The company would get paid for
writing the loan but then not bear any risk for how the loan actually performed. Third, when the financial crisis
started, the government bailed out banks and other financial institutions (and the automobile industry).
Protections Against Moral Hazard
Sometimes, governments attempt to regulate away risky behavior. This is the case with the federal deposit
insurance and banks. Because bank deposits are insured, consumers do not have to worry if their bank goes
under. They will still get their money. That leads consumers to ignore bank risk when deciding where to
deposit their money and instead focus on which bank offers the best interest rates. Banks can only offer
higher interest rates if they are able to generate a higher return on their loans. That is, the riskier loans banks
make, the more interest they earn, and the more interest they can pay to their customers to attract more
deposits. Since banking regulators are well aware of these incentives, they attempt to regulate bank lending
activity.
When firms engage in risky activity but are bailed out when the risks do not work out, there is no incentive for
the firms to change their behavior and engage in less risky behavior.
Learning Activities (Nongraded)
Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit
them. If you have questions, contact your instructor for further guidance and information.
In order to check your understanding of concepts
covered in this unit, complete the Unit VII Check for
Understanding activity.
Unit VII Activity Alternate Format PDF
NOTE: Be sure to maximize your internet browser
so that no part of the presentation gets cut off.
**## UnitVIIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VIII
At the end of this unit, you should be able to:
1. Evaluate the ethical outcomes of free market outcomes using supply and demand models.
2. Apply the different types of elasticity concepts to business scenarios.
3. Analyze how price and output influence profit maximization under different market structures.
4. Evaluate strategic pricing decisions.
5. Apply game theory to pricing and to output decisions in an oligopoly market.
6. Analyze the basis of trade.
7. Explain the implications of uncertainty in managerial decision-making.
7.4 Explain how incentives can affect various relationships in an organization.
Required Unit Resources
Chapter 4: Extent (How Much) Decisions (ULO 7.4)
Chapter 21: Getting Employees to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 22: Getting Divisions to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 23: Managing Vertical Relationships (ULO 7.4)
Unit Lesson
Lesson: Organizational Design and Incentives (ULO 7.4)
This lesson covers the topics introduced in this final unit.
The last unit’s topic on asymmetric information included a section on shirking. Recall that shirking is when
employees do not work hard because the managers are not able to monitor their performance (either because
of ability or cost). Another way to look at the problem of shirking is through the principal-agent problem. In the
principal-agent problem, the principal (typically a business owner) wants their agent (typically the employee)
to act on the principal’s behalf. The problem is that the agent often has different goals than the principal.
Incentives
Incentives are one way to correct shirking and solve the principal-agent problem. Incentives can be tied
directly to performance, such as commissions, as discussed in the last unit. Incentives can also be tied to
specific actions or the overall performance of the company. Basing incentives on company performance can
be dicey though. There are many factors outside the employees’ control that affect company performance.
The less tied incentives are to employee performance, the less likely the incentives will be to promote the
desired performance. Still, tying incentives to company performance does help align the goals of the principal
and the agent.
UNIT VIII STUDY GUIDE
Organizational Design and Incentives
ECO 6301, Economics for Managers 2
UNIT x STUDY GUIDE
Title
As mentioned, employees may not have a lot of control over company performance, which can complicate
attempts to align principal and agent goals. This can be because of large outside influences (demand for the
product) or because of the nature of the job agents have. Perhaps agents have the information to promote the
principal’s goals but lack the decision-making authority to realize them. In cases like this, it is important for
principals to align decision-making power with those who have information.
One model for aligning goals and addressing the principal-agent problem is the franchise model. In a
franchise model, a parent company, or brand, franchises out the opportunity to open additional stores under
the brand name for a percentage of sales. If a brand opened company-owned stores, they would have to rely
on managers who may not be as motivated, or the job may attract unmotivated managers (recall the different
explanation for similar problems with moral hazard and adverse selection). With a franchise model, however,
the individual franchise owner is motivated to make the franchise a success, since that determines the profit.
When companies grow, they are often divided into different divisions. Incentives can be tricky in ensuring the
divisions are working toward the same goal. If the incentives are not structured correctly, the divisions may
make decisions that are best for the division but not best for the company.
Take for example a college admissions department and an academic department. The academic department
might be interested in producing quality graduates that will earn the school a good reputation. The academic
department can help realize those goals with stricter admissions standards. The admissions department,
however, might be interested in reducing admissions standards in order to admit as many people as possible
(or at least enough to meet departmental goals). Stricter admissions standards get in the way of admissions.
Having too many, low quality students in a program can detract from the attention focused to turn the higher
quality students into reputable graduates who will help build the department’s reputation. Sharing information
and aligning the goals of the departments is key to getting both departments to act in the interest of the school
as a whole.
Sometimes there are exchanges between divisions in an organization. Tracking this and crediting each
division is important. Transfer pricing is the price of an intermediate good, made in-house, and then “sold” to
another division. Transfer pricing might be thought of most easily with manufacturing. When making a car, the
engine is built and then put into the frame. Since it is just the car that is ultimately sold at a price, crediting the
division that built the engine can be difficult. Obviously, the car would not be much good without the engine.
Determining the price for the engine, however, is difficult and often controversial between the divisions. The
engine division will want to be credited with a high price for the engine, but the division that built the frame will
want to “pay” a low price for the engine. Each division wants to appear as profitable as possible. Giving one
division an unfair price could hurt morale, and thus productivity, in that division. That would, obviously, hurt
the company overall.
Transfer pricing issues can be addressed by treating different divisions as profit centers or cost centers. Profit
centers are evaluated based on profit or revenue. Cost centers are evaluated based on costs. Using these
different centers and different goals, as long as the divisions are aligned to the proper center, their goals will
align with helping the overall organization be more successful.
Organizations can be ordered based on a variety of plans. Organizations might be organized by function,
such as production and sales. Organizations can also be organized by products or by geographic region. The
best organizational structure will depend on the type of firm and how they approach the market.
Vertical Relationships
Firms can also find profit potential by expanding operations vertically through their supply chain. This strategy
is known as a vertical relationship. For a simple example of this, consider a landlord, particularly one
constrained by rent control laws. The landlord may find him- or herself constrained in what he or she can
charge for rent. There are other services, however, that can be provided to tenants beyond just the living
space. A landlord might, for example, furnish the apartment for an extra fee. Firms can even use exclusions,
forcing buyers to purchase their additional product or service rather than purchasing from a competitor. A
similar approach is taken with movie theaters or ballparks who sell the tickets to the event and then also
require that if customers want to enjoy refreshments, they must do so at the concession stands operated by
the event.
ECO 6301, Economics for Managers 3
UNIT x STUDY GUIDE
Title
Vertical relationships can also be used to manipulate realized profit. A firm may produce an early stage of a
product in a high tax area but transfer the production to another location with lower taxes for finalization. The
transfer can be done at a low price so that the high tax production does not produce much profit and then the
product is sold by the low tax production area with a higher profit realized thanks to the low transfer/purchase
price. The reverse can also be done where firms build in profit all along the production pipeline. This is known
as double marginalization. Of course, if the markups are too much then the price of the product in the market
will be too high.
Sometimes the incentives between links in the supply chain, for example between manufacturers and
retailers, come into conflict. Manufacturers might have an incentive to have the quality of their product
maintained and displayed but the retailer many not have quite the same concern. Have you ever been in a
store that sells high quality stereos and speakers? You might notice a special room set up to listen to the
speakers. This is by the design of the stereo and speaker producer, not necessarily the store. The purpose is
to provide an environment where you can really hear the quality of the higher priced stereos and speakers. In
exchange for providing the fancy displays, the manufacturers put minimum prices on their products wherever
they are sold. The purpose of these minimum prices is to prevent the fancy store from spending money on the
display only to have consumers come in, listen to the stereos and speakers, decide what they want, and go to
Walmart to buy it for a cheaper price.
Similarly, you generally will not see retailers engage in too much advertising. Advertising is mostly handled by
the producers of the product. A retailer advertising for a particular good may end up convincing consumers to
buy the product but not necessarily from their location.
Too much in the way of vertical relationships, however, can raise antitrust concerns. Strong vertical
relationships can have a negative effect on market competition, so many countries have antitrust laws
governing vertical relationships. In Europe, for example, Coke is prohibited from purchasing refrigerators in
their retail locations. The fear is that Coke owning the refrigerators will lead to the exclusion of other soft drink
producers being able to provide their product cold and ready to drink. So, vertical relationships can come with
much potential for firms, but they can also come with risks firms should be aware of before pursuing them.
A final word on vertical relationships—vertical relationships can be pursued through mergers. Simply merging
with another organization in a business’s supply chain does not always work out. In a free market, where
buyers and sellers are rational and have full information, the sellers would only accept a price equal to the
discounted stream of future profits. That means, all else equal, the best the purchasing firm could expect to
do is break even on the purchase. The potential for the merger to work out is based on some type of synergy
to be realized that makes the purchased company/asset more valuable for being part of the purchasing
company. Perhaps the smaller company will benefit from a larger distribution system already in place with the
purchasing company.
Suggested Unit Resources
Article: An Evaluation of Alternative Market-Based Transfer Prices (Optional)
This article further explores the topics covered in this unit.
**## UnitVIIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VIII
At the end of this unit, you should be able to:
1. Evaluate the ethical outcomes of free market outcomes using supply and demand models.
2. Apply the different types of elasticity concepts to business scenarios.
3. Analyze how price and output influence profit maximization under different market structures.
4. Evaluate strategic pricing decisions.
5. Apply game theory to pricing and to output decisions in an oligopoly market.
6. Analyze the basis of trade.
7. Explain the implications of uncertainty in managerial decision-making.
7.4 Explain how incentives can affect various relationships in an organization.
Required Unit Resources
Chapter 4: Extent (How Much) Decisions (ULO 7.4)
Chapter 21: Getting Employees to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 22: Getting Divisions to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 23: Managing Vertical Relationships (ULO 7.4)
Unit Lesson
Lesson: Organizational Design and Incentives (ULO 7.4)
This lesson covers the topics introduced in this final unit.
The last unit’s topic on asymmetric information included a section on shirking. Recall that shirking is when
employees do not work hard because the managers are not able to monitor their performance (either because
of ability or cost). Another way to look at the problem of shirking is through the principal-agent problem. In the
principal-agent problem, the principal (typically a business owner) wants their agent (typically the employee)
to act on the principal’s behalf. The problem is that the agent often has different goals than the principal.
Incentives
Incentives are one way to correct shirking and solve the principal-agent problem. Incentives can be tied
directly to performance, such as commissions, as discussed in the last unit. Incentives can also be tied to
specific actions or the overall performance of the company. Basing incentives on company performance can
be dicey though. There are many factors outside the employees’ control that affect company performance.
The less tied incentives are to employee performance, the less likely the incentives will be to promote the
desired performance. Still, tying incentives to company performance does help align the goals of the principal
and the agent.
UNIT VIII STUDY GUIDE
Organizational Design and Incentives
ECO 6301, Economics for Managers 2
UNIT x STUDY GUIDE
Title
As mentioned, employees may not have a lot of control over company performance, which can complicate
attempts to align principal and agent goals. This can be because of large outside influences (demand for the
product) or because of the nature of the job agents have. Perhaps agents have the information to promote the
principal’s goals but lack the decision-making authority to realize them. In cases like this, it is important for
principals to align decision-making power with those who have information.
One model for aligning goals and addressing the principal-agent problem is the franchise model. In a
franchise model, a parent company, or brand, franchises out the opportunity to open additional stores under
the brand name for a percentage of sales. If a brand opened company-owned stores, they would have to rely
on managers who may not be as motivated, or the job may attract unmotivated managers (recall the different
explanation for similar problems with moral hazard and adverse selection). With a franchise model, however,
the individual franchise owner is motivated to make the franchise a success, since that determines the profit.
When companies grow, they are often divided into different divisions. Incentives can be tricky in ensuring the
divisions are working toward the same goal. If the incentives are not structured correctly, the divisions may
make decisions that are best for the division but not best for the company.
Take for example a college admissions department and an academic department. The academic department
might be interested in producing quality graduates that will earn the school a good reputation. The academic
department can help realize those goals with stricter admissions standards. The admissions department,
however, might be interested in reducing admissions standards in order to admit as many people as possible
(or at least enough to meet departmental goals). Stricter admissions standards get in the way of admissions.
Having too many, low quality students in a program can detract from the attention focused to turn the higher
quality students into reputable graduates who will help build the department’s reputation. Sharing information
and aligning the goals of the departments is key to getting both departments to act in the interest of the school
as a whole.
Sometimes there are exchanges between divisions in an organization. Tracking this and crediting each
division is important. Transfer pricing is the price of an intermediate good, made in-house, and then “sold” to
another division. Transfer pricing might be thought of most easily with manufacturing. When making a car, the
engine is built and then put into the frame. Since it is just the car that is ultimately sold at a price, crediting the
division that built the engine can be difficult. Obviously, the car would not be much good without the engine.
Determining the price for the engine, however, is difficult and often controversial between the divisions. The
engine division will want to be credited with a high price for the engine, but the division that built the frame will
want to “pay” a low price for the engine. Each division wants to appear as profitable as possible. Giving one
division an unfair price could hurt morale, and thus productivity, in that division. That would, obviously, hurt
the company overall.
Transfer pricing issues can be addressed by treating different divisions as profit centers or cost centers. Profit
centers are evaluated based on profit or revenue. Cost centers are evaluated based on costs. Using these
different centers and different goals, as long as the divisions are aligned to the proper center, their goals will
align with helping the overall organization be more successful.
Organizations can be ordered based on a variety of plans. Organizations might be organized by function,
such as production and sales. Organizations can also be organized by products or by geographic region. The
best organizational structure will depend on the type of firm and how they approach the market.
Vertical Relationships
Firms can also find profit potential by expanding operations vertically through their supply chain. This strategy
is known as a vertical relationship. For a simple example of this, consider a landlord, particularly one
constrained by rent control laws. The landlord may find him- or herself constrained in what he or she can
charge for rent. There are other services, however, that can be provided to tenants beyond just the living
space. A landlord might, for example, furnish the apartment for an extra fee. Firms can even use exclusions,
forcing buyers to purchase their additional product or service rather than purchasing from a competitor. A
similar approach is taken with movie theaters or ballparks who sell the tickets to the event and then also
require that if customers want to enjoy refreshments, they must do so at the concession stands operated by
the event.
ECO 6301, Economics for Managers 3
UNIT x STUDY GUIDE
Title
Vertical relationships can also be used to manipulate realized profit. A firm may produce an early stage of a
product in a high tax area but transfer the production to another location with lower taxes for finalization. The
transfer can be done at a low price so that the high tax production does not produce much profit and then the
product is sold by the low tax production area with a higher profit realized thanks to the low transfer/purchase
price. The reverse can also be done where firms build in profit all along the production pipeline. This is known
as double marginalization. Of course, if the markups are too much then the price of the product in the market
will be too high.
Sometimes the incentives between links in the supply chain, for example between manufacturers and
retailers, come into conflict. Manufacturers might have an incentive to have the quality of their product
maintained and displayed but the retailer many not have quite the same concern. Have you ever been in a
store that sells high quality stereos and speakers? You might notice a special room set up to listen to the
speakers. This is by the design of the stereo and speaker producer, not necessarily the store. The purpose is
to provide an environment where you can really hear the quality of the higher priced stereos and speakers. In
exchange for providing the fancy displays, the manufacturers put minimum prices on their products wherever
they are sold. The purpose of these minimum prices is to prevent the fancy store from spending money on the
display only to have consumers come in, listen to the stereos and speakers, decide what they want, and go to
Walmart to buy it for a cheaper price.
Similarly, you generally will not see retailers engage in too much advertising. Advertising is mostly handled by
the producers of the product. A retailer advertising for a particular good may end up convincing consumers to
buy the product but not necessarily from their location.
Too much in the way of vertical relationships, however, can raise antitrust concerns. Strong vertical
relationships can have a negative effect on market competition, so many countries have antitrust laws
governing vertical relationships. In Europe, for example, Coke is prohibited from purchasing refrigerators in
their retail locations. The fear is that Coke owning the refrigerators will lead to the exclusion of other soft drink
producers being able to provide their product cold and ready to drink. So, vertical relationships can come with
much potential for firms, but they can also come with risks firms should be aware of before pursuing them.
A final word on vertical relationships—vertical relationships can be pursued through mergers. Simply merging
with another organization in a business’s supply chain does not always work out. In a free market, where
buyers and sellers are rational and have full information, the sellers would only accept a price equal to the
discounted stream of future profits. That means, all else equal, the best the purchasing firm could expect to
do is break even on the purchase. The potential for the merger to work out is based on some type of synergy
to be realized that makes the purchased company/asset more valuable for being part of the purchasing
company. Perhaps the smaller company will benefit from a larger distribution system already in place with the
purchasing company.
Suggested Unit Resources
Article: An Evaluation of Alternative Market-Based Transfer Prices (Optional)
This article further explores the topics covered in this unit.
**## EconomicsforManagersECO6301UnitVIIIFinalProject.docx**
2
Economics for Managers ECO 6301
**Unit VIII Final Project**
This assignment measures your mastery of CLOs 1, 2, 3, 4, 5, and 6 and ULOs 7.3 and 7.4
**A Case Analysis of AMC**
**Assignment objective:** AMC is the largest movie theater operator in the world. AMC recently became a popular meme stock. Take a few minutes to learn more about
AMC Theaters. https://www.amctheatres.com/
**Length:** Your submission is required to be at least 5 pages in length and not more than 7 pages, not including the title page and references.
**References:** A minimum of 3 peer-reviewed references are required, any additional resources used are required to be scholarly/academic in nature and found in the CSU Library. APA formatting is required to be used for citations and references. Use this definition to define the term in the instructions.
**Definitions:** Scholarly journals are sometimes called academic journals. The terms are often used interchangeably to describe the same type of publication. These types of publications are published by universities, academic institutions, professional associations, and commercial enterprises and are compiled by scholars, academics, and other subject authorities.
**Details:** In your paper, include the following:
· Introduction
· Analyze the market before the COVID-19 pandemic. Describe how the pandemic affected the movie theater industry.
· Explain price discrimination in the movie theater market.
· Movie theater employees are generally paid hourly. Design an incentive pay structure for AMC Theaters and explain how it would work.
· Apply the concepts of economies of scale and economies of scope to AMC Theater's business model
· Apply the concepts of game theory to short selling and meme stocks as it relates to AMC Theaters
· Assess AMC Theater's potential for international expansion and potential trade policy issues.
· Explain the asymmetric information issues that lead to short selling and meme stocks.
· Apply the concepts of moral hazard to short selling and meme stocks, using AMC as an example.
· Conclusion
**## UnitVIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VII
At the end of this unit, you should be able to:
7. Explain the implications of uncertainty in managerial decision-making.
7.3 Compare moral hazard and adverse selection.
Required Unit Resources
Chapter 19: The Problem of Adverse Selection (ULO 7.3)
Chapter 20: The Problem of Moral Hazard (ULO 7.3)
Unit Lesson
Lesson: Adverse Selection and Moral Hazard (ULO 7.3)
This lesson introduces you to the topics covered in this unit: adverse selection and moral hazard.
Problems of uncertainty and incomplete information can create a variety of problems for business decision-
making. Two of those problems, adverse selection and moral hazard, will be the topics of this lesson. They
are both types of information asymmetries, where one party to an interaction has more information than the
other party.
Adverse Selection
Adverse selection occurs when one party is better informed about product quality than the other party. This
information difference specifically leads people to self-select in or out of a particular group, leading to
potentially problematic outcomes. To see these outcomes, consider the example of insurance.
Insurance is intended to cover people when something unexpected happens. People pay into a pool of money
(managed by an insurance company) and are then paid out if events covered by their insurance happen. You
likely have experience with health insurance, car insurance, and life insurance. The model works if there are
more people paying into the pool than drawing from the pool. People benefit from insurance if an unexpected
event happens to them and people lose if an event does not happen to them; although, there is still benefit
from security against risk even if the event does not happen. Ultimately, insurance works because people
tend to be risk-averse.
Recall the coin-flipping example from Unit VI. Since the expected value of the game is $0, a risk-neutral
person is completely indifferent to playing the game because they will expect to win nothing and lose nothing.
A risk-averse person would not want to participate in the coin-flipping activity because they have a greater
fear of losing than hope of winning a dollar. A risk-seeking person puts more weight on the positive outcome
from a risk so they would be more likely to engage in the coin-flipping activity.
You might see the potential adverse selection problem with insurance. People with a low probability of the
event happening to them are less likely to join the insurance pool while people with a high probability of the
event happening to them are more likely to join the insurance pool. This happens when young, healthy people
opt not to buy health insurance. It is why life insurance companies market to young people to buy insurance
now (that is, buy it when they likely do not need it). A pool of people made up primarily of people likely to use
insurance will put the insurance company out of business.
UNIT VII STUDY GUIDE
Adverse Selection and Moral Hazard
ECO 6301, Economics for Managers 2
UNIT x STUDY GUIDE
Title
Consider other types of insurance and how well they work. Who is likely to buy vision insurance? Most likely
people who already need glasses. As a result, there is not a very good cost-benefit to the consumer for vision
insurance. That is, the amount consumers pay in premiums is close to the maximum benefit they can get from
their insurance each year.
Protections Against Adverse Selection
As a consumer, the best way to deal with adverse selection is to recognize when it will likely happen, which
group you are likely to be in, and make your decisions accordingly. If you have perfect vision, for example,
there is not a need to get vision insurance. Consumer perception of adverse selection can also be
problematic for companies. In the market for used cars, consumers might believe that the only reason
somebody would look to sell their used car is if something is wrong with it. That is, consumers view the
market for used cars as an adverse selection problem. Given those assumptions, consumers would decrease
the amount they are willing to pay for a used car. So how can companies overcome these consumer
perceptions and consumer selection problems?
One way companies can overcome adverse selection is by screening consumers. Life insurance companies
screen prospective customers by asking for medical history. Car insurance companies consider past driving
record, age, gender, and marital status in setting premiums (or even if they will offer insurance) for customers.
Going back to the used car market, consumers can request a mechanic review of a car to screen bad cars
(or, to overcome the problem on their end, the seller offers certification of the car passing an inspection).
Another way to overcome the adverse selection problem is with signaling. Signaling occurs when one party
attempts to reveal information about themselves that other parties cannot duplicate. Education, for example,
is part signal. Getting a degree is a signal to potential employers of a certain level of competence and
problem-solving ability. People without the same level of competence and problem solving would not, the
thinking goes, be able to earn the degree. From the business perspective, advertising and branding can serve
as signals. Businesses would not bother to spend the money on advertising unless their product was worth
advertising. Similarly, established brand names send a signal to consumers that there is a reason the brand
has been established. Whether the brand is for low cost or for high quality, consumers can feel comfortable
knowing the brand will be as expected.
Adverse selection can happen in areas other than insurance. It can be particularly important for data analysis.
Imagine you need to figure out how much interest there is in a new product or service and you decide to
survey people to get your data. You go to the mall and ask people if they would like to participate in your
survey. Because you can only survey people who are willing to take your survey, you will only get responses
from people who opt to give up some of their shopping time to take your survey. Who might this be? It might
be mostly people who are just out for leisurely entertainment and do not have anything better to do. People
who have a high value for their time naturally opt out of taking your survey, and your data will not include
information on those types of people. That is, your survey will be biased.
Moral Hazard
Another type of asymmetry is moral hazard. One quick point on moral hazard is that it does not really have
anything to do with morals. Students sometimes fixate on the word moral and assume it has to do with people
acting immorally. It does not. Some may view the actions in a moral hazard as immoral, but moral hazard still
refers to specific incentives and actions, not morality generally.
Moral hazard occurs when one party does not bear the risks for the actions they take. Turning back to
insurance, a person with health insurance might be more likely to engage in risky activity knowing they will not
have to pay all of their medical bills. With car insurance, a driver might be less careful on the road knowing
their car would be replaced by the insurance company if they got into an accident.
Moral hazard and adverse selection can often explain similar events but the explanations are different.
Adverse selection would suggest that risky drivers would be more likely to buy cars with airbags. Moral
hazard would suggest that because a car has air bags, drivers are likely to take more risks when driving.
Ultimately, the difference is that adverse selection is about hidden information while moral hazard is about
hidden actions.
ECO 6301, Economics for Managers 3
UNIT x STUDY GUIDE
Title
Another type of moral hazard is when firms hire workers, but monitoring their behavior is either difficult or
costly. Without monitoring, employees can shirk in their job duties without repercussions. Potential shirking is
one reason to pay salespeople commission. Salespeople who shirk and do not make sales will not earn much
income. Shirking costs both the firm and the employee money as firms have less desire to pay workers in fear
they will shirk or have less money to pay workers because they have to pay for monitoring. Shirking leads into
the principal-agent problem, which will be covered in Unit VIII.
Moral hazard also played an important role in the 2008 financial crisis. Lending money already involves some
moral hazard. Borrowers engage in riskier activity with someone else’s money than they are willing to engage
in with their own money (the borrower, after all, is not risking their own money when they make a big
purchase, they are only risking a future promise to pay the money; a promise they can break). In the financial
crisis, however, banks were bailed out for their risky decisions in a variety of ways. First, their loans were
often insured by Fannie Mae and Freddie Mac. Second, many mortgage companies would write the loan and
then sell the loan so they were not the ones actually servicing the loan. The company would get paid for
writing the loan but then not bear any risk for how the loan actually performed. Third, when the financial crisis
started, the government bailed out banks and other financial institutions (and the automobile industry).
Protections Against Moral Hazard
Sometimes, governments attempt to regulate away risky behavior. This is the case with the federal deposit
insurance and banks. Because bank deposits are insured, consumers do not have to worry if their bank goes
under. They will still get their money. That leads consumers to ignore bank risk when deciding where to
deposit their money and instead focus on which bank offers the best interest rates. Banks can only offer
higher interest rates if they are able to generate a higher return on their loans. That is, the riskier loans banks
make, the more interest they earn, and the more interest they can pay to their customers to attract more
deposits. Since banking regulators are well aware of these incentives, they attempt to regulate bank lending
activity.
When firms engage in risky activity but are bailed out when the risks do not work out, there is no incentive for
the firms to change their behavior and engage in less risky behavior.
Learning Activities (Nongraded)
Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit
them. If you have questions, contact your instructor for further guidance and information.
In order to check your understanding of concepts
covered in this unit, complete the Unit VII Check for
Understanding activity.
Unit VII Activity Alternate Format PDF
NOTE: Be sure to maximize your internet browser
so that no part of the presentation gets cut off.
**## UnitVIIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VIII
At the end of this unit, you should be able to:
1. Evaluate the ethical outcomes of free market outcomes using supply and demand models.
2. Apply the different types of elasticity concepts to business scenarios.
3. Analyze how price and output influence profit maximization under different market structures.
4. Evaluate strategic pricing decisions.
5. Apply game theory to pricing and to output decisions in an oligopoly market.
6. Analyze the basis of trade.
7. Explain the implications of uncertainty in managerial decision-making.
7.4 Explain how incentives can affect various relationships in an organization.
Required Unit Resources
Chapter 4: Extent (How Much) Decisions (ULO 7.4)
Chapter 21: Getting Employees to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 22: Getting Divisions to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 23: Managing Vertical Relationships (ULO 7.4)
Unit Lesson
Lesson: Organizational Design and Incentives (ULO 7.4)
This lesson covers the topics introduced in this final unit.
The last unit’s topic on asymmetric information included a section on shirking. Recall that shirking is when
employees do not work hard because the managers are not able to monitor their performance (either because
of ability or cost). Another way to look at the problem of shirking is through the principal-agent problem. In the
principal-agent problem, the principal (typically a business owner) wants their agent (typically the employee)
to act on the principal’s behalf. The problem is that the agent often has different goals than the principal.
Incentives
Incentives are one way to correct shirking and solve the principal-agent problem. Incentives can be tied
directly to performance, such as commissions, as discussed in the last unit. Incentives can also be tied to
specific actions or the overall performance of the company. Basing incentives on company performance can
be dicey though. There are many factors outside the employees’ control that affect company performance.
The less tied incentives are to employee performance, the less likely the incentives will be to promote the
desired performance. Still, tying incentives to company performance does help align the goals of the principal
and the agent.
UNIT VIII STUDY GUIDE
Organizational Design and Incentives
ECO 6301, Economics for Managers 2
UNIT x STUDY GUIDE
Title
As mentioned, employees may not have a lot of control over company performance, which can complicate
attempts to align principal and agent goals. This can be because of large outside influences (demand for the
product) or because of the nature of the job agents have. Perhaps agents have the information to promote the
principal’s goals but lack the decision-making authority to realize them. In cases like this, it is important for
principals to align decision-making power with those who have information.
One model for aligning goals and addressing the principal-agent problem is the franchise model. In a
franchise model, a parent company, or brand, franchises out the opportunity to open additional stores under
the brand name for a percentage of sales. If a brand opened company-owned stores, they would have to rely
on managers who may not be as motivated, or the job may attract unmotivated managers (recall the different
explanation for similar problems with moral hazard and adverse selection). With a franchise model, however,
the individual franchise owner is motivated to make the franchise a success, since that determines the profit.
When companies grow, they are often divided into different divisions. Incentives can be tricky in ensuring the
divisions are working toward the same goal. If the incentives are not structured correctly, the divisions may
make decisions that are best for the division but not best for the company.
Take for example a college admissions department and an academic department. The academic department
might be interested in producing quality graduates that will earn the school a good reputation. The academic
department can help realize those goals with stricter admissions standards. The admissions department,
however, might be interested in reducing admissions standards in order to admit as many people as possible
(or at least enough to meet departmental goals). Stricter admissions standards get in the way of admissions.
Having too many, low quality students in a program can detract from the attention focused to turn the higher
quality students into reputable graduates who will help build the department’s reputation. Sharing information
and aligning the goals of the departments is key to getting both departments to act in the interest of the school
as a whole.
Sometimes there are exchanges between divisions in an organization. Tracking this and crediting each
division is important. Transfer pricing is the price of an intermediate good, made in-house, and then “sold” to
another division. Transfer pricing might be thought of most easily with manufacturing. When making a car, the
engine is built and then put into the frame. Since it is just the car that is ultimately sold at a price, crediting the
division that built the engine can be difficult. Obviously, the car would not be much good without the engine.
Determining the price for the engine, however, is difficult and often controversial between the divisions. The
engine division will want to be credited with a high price for the engine, but the division that built the frame will
want to “pay” a low price for the engine. Each division wants to appear as profitable as possible. Giving one
division an unfair price could hurt morale, and thus productivity, in that division. That would, obviously, hurt
the company overall.
Transfer pricing issues can be addressed by treating different divisions as profit centers or cost centers. Profit
centers are evaluated based on profit or revenue. Cost centers are evaluated based on costs. Using these
different centers and different goals, as long as the divisions are aligned to the proper center, their goals will
align with helping the overall organization be more successful.
Organizations can be ordered based on a variety of plans. Organizations might be organized by function,
such as production and sales. Organizations can also be organized by products or by geographic region. The
best organizational structure will depend on the type of firm and how they approach the market.
Vertical Relationships
Firms can also find profit potential by expanding operations vertically through their supply chain. This strategy
is known as a vertical relationship. For a simple example of this, consider a landlord, particularly one
constrained by rent control laws. The landlord may find him- or herself constrained in what he or she can
charge for rent. There are other services, however, that can be provided to tenants beyond just the living
space. A landlord might, for example, furnish the apartment for an extra fee. Firms can even use exclusions,
forcing buyers to purchase their additional product or service rather than purchasing from a competitor. A
similar approach is taken with movie theaters or ballparks who sell the tickets to the event and then also
require that if customers want to enjoy refreshments, they must do so at the concession stands operated by
the event.
ECO 6301, Economics for Managers 3
UNIT x STUDY GUIDE
Title
Vertical relationships can also be used to manipulate realized profit. A firm may produce an early stage of a
product in a high tax area but transfer the production to another location with lower taxes for finalization. The
transfer can be done at a low price so that the high tax production does not produce much profit and then the
product is sold by the low tax production area with a higher profit realized thanks to the low transfer/purchase
price. The reverse can also be done where firms build in profit all along the production pipeline. This is known
as double marginalization. Of course, if the markups are too much then the price of the product in the market
will be too high.
Sometimes the incentives between links in the supply chain, for example between manufacturers and
retailers, come into conflict. Manufacturers might have an incentive to have the quality of their product
maintained and displayed but the retailer many not have quite the same concern. Have you ever been in a
store that sells high quality stereos and speakers? You might notice a special room set up to listen to the
speakers. This is by the design of the stereo and speaker producer, not necessarily the store. The purpose is
to provide an environment where you can really hear the quality of the higher priced stereos and speakers. In
exchange for providing the fancy displays, the manufacturers put minimum prices on their products wherever
they are sold. The purpose of these minimum prices is to prevent the fancy store from spending money on the
display only to have consumers come in, listen to the stereos and speakers, decide what they want, and go to
Walmart to buy it for a cheaper price.
Similarly, you generally will not see retailers engage in too much advertising. Advertising is mostly handled by
the producers of the product. A retailer advertising for a particular good may end up convincing consumers to
buy the product but not necessarily from their location.
Too much in the way of vertical relationships, however, can raise antitrust concerns. Strong vertical
relationships can have a negative effect on market competition, so many countries have antitrust laws
governing vertical relationships. In Europe, for example, Coke is prohibited from purchasing refrigerators in
their retail locations. The fear is that Coke owning the refrigerators will lead to the exclusion of other soft drink
producers being able to provide their product cold and ready to drink. So, vertical relationships can come with
much potential for firms, but they can also come with risks firms should be aware of before pursuing them.
A final word on vertical relationships—vertical relationships can be pursued through mergers. Simply merging
with another organization in a business’s supply chain does not always work out. In a free market, where
buyers and sellers are rational and have full information, the sellers would only accept a price equal to the
discounted stream of future profits. That means, all else equal, the best the purchasing firm could expect to
do is break even on the purchase. The potential for the merger to work out is based on some type of synergy
to be realized that makes the purchased company/asset more valuable for being part of the purchasing
company. Perhaps the smaller company will benefit from a larger distribution system already in place with the
purchasing company.
Suggested Unit Resources
Article: An Evaluation of Alternative Market-Based Transfer Prices (Optional)
This article further explores the topics covered in this unit.
**## EconomicsforManagersECO6301UnitVIIIFinalProject.docx**
2
Economics for Managers ECO 6301
**Unit VIII Final Project**
This assignment measures your mastery of CLOs 1, 2, 3, 4, 5, and 6 and ULOs 7.3 and 7.4
**A Case Analysis of AMC**
**Assignment objective:** AMC is the largest movie theater operator in the world. AMC recently became a popular meme stock. Take a few minutes to learn more about
AMC Theaters. https://www.amctheatres.com/
**Length:** Your submission is required to be at least 5 pages in length and not more than 7 pages, not including the title page and references.
**References:** A minimum of 3 peer-reviewed references are required, any additional resources used are required to be scholarly/academic in nature and found in the CSU Library. APA formatting is required to be used for citations and references. Use this definition to define the term in the instructions.
**Definitions:** Scholarly journals are sometimes called academic journals. The terms are often used interchangeably to describe the same type of publication. These types of publications are published by universities, academic institutions, professional associations, and commercial enterprises and are compiled by scholars, academics, and other subject authorities.
**Details:** In your paper, include the following:
· Introduction
· Analyze the market before the COVID-19 pandemic. Describe how the pandemic affected the movie theater industry.
· Explain price discrimination in the movie theater market.
· Movie theater employees are generally paid hourly. Design an incentive pay structure for AMC Theaters and explain how it would work.
· Apply the concepts of economies of scale and economies of scope to AMC Theater's business model
· Apply the concepts of game theory to short selling and meme stocks as it relates to AMC Theaters
· Assess AMC Theater's potential for international expansion and potential trade policy issues.
· Explain the asymmetric information issues that lead to short selling and meme stocks.
· Apply the concepts of moral hazard to short selling and meme stocks, using AMC as an example.
· Conclusion
**## UnitVIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VII
At the end of this unit, you should be able to:
7. Explain the implications of uncertainty in managerial decision-making.
7.3 Compare moral hazard and adverse selection.
Required Unit Resources
Chapter 19: The Problem of Adverse Selection (ULO 7.3)
Chapter 20: The Problem of Moral Hazard (ULO 7.3)
Unit Lesson
Lesson: Adverse Selection and Moral Hazard (ULO 7.3)
This lesson introduces you to the topics covered in this unit: adverse selection and moral hazard.
Problems of uncertainty and incomplete information can create a variety of problems for business decision-
making. Two of those problems, adverse selection and moral hazard, will be the topics of this lesson. They
are both types of information asymmetries, where one party to an interaction has more information than the
other party.
Adverse Selection
Adverse selection occurs when one party is better informed about product quality than the other party. This
information difference specifically leads people to self-select in or out of a particular group, leading to
potentially problematic outcomes. To see these outcomes, consider the example of insurance.
Insurance is intended to cover people when something unexpected happens. People pay into a pool of money
(managed by an insurance company) and are then paid out if events covered by their insurance happen. You
likely have experience with health insurance, car insurance, and life insurance. The model works if there are
more people paying into the pool than drawing from the pool. People benefit from insurance if an unexpected
event happens to them and people lose if an event does not happen to them; although, there is still benefit
from security against risk even if the event does not happen. Ultimately, insurance works because people
tend to be risk-averse.
Recall the coin-flipping example from Unit VI. Since the expected value of the game is $0, a risk-neutral
person is completely indifferent to playing the game because they will expect to win nothing and lose nothing.
A risk-averse person would not want to participate in the coin-flipping activity because they have a greater
fear of losing than hope of winning a dollar. A risk-seeking person puts more weight on the positive outcome
from a risk so they would be more likely to engage in the coin-flipping activity.
You might see the potential adverse selection problem with insurance. People with a low probability of the
event happening to them are less likely to join the insurance pool while people with a high probability of the
event happening to them are more likely to join the insurance pool. This happens when young, healthy people
opt not to buy health insurance. It is why life insurance companies market to young people to buy insurance
now (that is, buy it when they likely do not need it). A pool of people made up primarily of people likely to use
insurance will put the insurance company out of business.
UNIT VII STUDY GUIDE
Adverse Selection and Moral Hazard
ECO 6301, Economics for Managers 2
UNIT x STUDY GUIDE
Title
Consider other types of insurance and how well they work. Who is likely to buy vision insurance? Most likely
people who already need glasses. As a result, there is not a very good cost-benefit to the consumer for vision
insurance. That is, the amount consumers pay in premiums is close to the maximum benefit they can get from
their insurance each year.
Protections Against Adverse Selection
As a consumer, the best way to deal with adverse selection is to recognize when it will likely happen, which
group you are likely to be in, and make your decisions accordingly. If you have perfect vision, for example,
there is not a need to get vision insurance. Consumer perception of adverse selection can also be
problematic for companies. In the market for used cars, consumers might believe that the only reason
somebody would look to sell their used car is if something is wrong with it. That is, consumers view the
market for used cars as an adverse selection problem. Given those assumptions, consumers would decrease
the amount they are willing to pay for a used car. So how can companies overcome these consumer
perceptions and consumer selection problems?
One way companies can overcome adverse selection is by screening consumers. Life insurance companies
screen prospective customers by asking for medical history. Car insurance companies consider past driving
record, age, gender, and marital status in setting premiums (or even if they will offer insurance) for customers.
Going back to the used car market, consumers can request a mechanic review of a car to screen bad cars
(or, to overcome the problem on their end, the seller offers certification of the car passing an inspection).
Another way to overcome the adverse selection problem is with signaling. Signaling occurs when one party
attempts to reveal information about themselves that other parties cannot duplicate. Education, for example,
is part signal. Getting a degree is a signal to potential employers of a certain level of competence and
problem-solving ability. People without the same level of competence and problem solving would not, the
thinking goes, be able to earn the degree. From the business perspective, advertising and branding can serve
as signals. Businesses would not bother to spend the money on advertising unless their product was worth
advertising. Similarly, established brand names send a signal to consumers that there is a reason the brand
has been established. Whether the brand is for low cost or for high quality, consumers can feel comfortable
knowing the brand will be as expected.
Adverse selection can happen in areas other than insurance. It can be particularly important for data analysis.
Imagine you need to figure out how much interest there is in a new product or service and you decide to
survey people to get your data. You go to the mall and ask people if they would like to participate in your
survey. Because you can only survey people who are willing to take your survey, you will only get responses
from people who opt to give up some of their shopping time to take your survey. Who might this be? It might
be mostly people who are just out for leisurely entertainment and do not have anything better to do. People
who have a high value for their time naturally opt out of taking your survey, and your data will not include
information on those types of people. That is, your survey will be biased.
Moral Hazard
Another type of asymmetry is moral hazard. One quick point on moral hazard is that it does not really have
anything to do with morals. Students sometimes fixate on the word moral and assume it has to do with people
acting immorally. It does not. Some may view the actions in a moral hazard as immoral, but moral hazard still
refers to specific incentives and actions, not morality generally.
Moral hazard occurs when one party does not bear the risks for the actions they take. Turning back to
insurance, a person with health insurance might be more likely to engage in risky activity knowing they will not
have to pay all of their medical bills. With car insurance, a driver might be less careful on the road knowing
their car would be replaced by the insurance company if they got into an accident.
Moral hazard and adverse selection can often explain similar events but the explanations are different.
Adverse selection would suggest that risky drivers would be more likely to buy cars with airbags. Moral
hazard would suggest that because a car has air bags, drivers are likely to take more risks when driving.
Ultimately, the difference is that adverse selection is about hidden information while moral hazard is about
hidden actions.
ECO 6301, Economics for Managers 3
UNIT x STUDY GUIDE
Title
Another type of moral hazard is when firms hire workers, but monitoring their behavior is either difficult or
costly. Without monitoring, employees can shirk in their job duties without repercussions. Potential shirking is
one reason to pay salespeople commission. Salespeople who shirk and do not make sales will not earn much
income. Shirking costs both the firm and the employee money as firms have less desire to pay workers in fear
they will shirk or have less money to pay workers because they have to pay for monitoring. Shirking leads into
the principal-agent problem, which will be covered in Unit VIII.
Moral hazard also played an important role in the 2008 financial crisis. Lending money already involves some
moral hazard. Borrowers engage in riskier activity with someone else’s money than they are willing to engage
in with their own money (the borrower, after all, is not risking their own money when they make a big
purchase, they are only risking a future promise to pay the money; a promise they can break). In the financial
crisis, however, banks were bailed out for their risky decisions in a variety of ways. First, their loans were
often insured by Fannie Mae and Freddie Mac. Second, many mortgage companies would write the loan and
then sell the loan so they were not the ones actually servicing the loan. The company would get paid for
writing the loan but then not bear any risk for how the loan actually performed. Third, when the financial crisis
started, the government bailed out banks and other financial institutions (and the automobile industry).
Protections Against Moral Hazard
Sometimes, governments attempt to regulate away risky behavior. This is the case with the federal deposit
insurance and banks. Because bank deposits are insured, consumers do not have to worry if their bank goes
under. They will still get their money. That leads consumers to ignore bank risk when deciding where to
deposit their money and instead focus on which bank offers the best interest rates. Banks can only offer
higher interest rates if they are able to generate a higher return on their loans. That is, the riskier loans banks
make, the more interest they earn, and the more interest they can pay to their customers to attract more
deposits. Since banking regulators are well aware of these incentives, they attempt to regulate bank lending
activity.
When firms engage in risky activity but are bailed out when the risks do not work out, there is no incentive for
the firms to change their behavior and engage in less risky behavior.
Learning Activities (Nongraded)
Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit
them. If you have questions, contact your instructor for further guidance and information.
In order to check your understanding of concepts
covered in this unit, complete the Unit VII Check for
Understanding activity.
Unit VII Activity Alternate Format PDF
NOTE: Be sure to maximize your internet browser
so that no part of the presentation gets cut off.
**## UnitVIIIStudyGuide.pdf**
ECO 6301, Economics for Managers 1
Course Learning Outcomes for Unit VIII
At the end of this unit, you should be able to:
1. Evaluate the ethical outcomes of free market outcomes using supply and demand models.
2. Apply the different types of elasticity concepts to business scenarios.
3. Analyze how price and output influence profit maximization under different market structures.
4. Evaluate strategic pricing decisions.
5. Apply game theory to pricing and to output decisions in an oligopoly market.
6. Analyze the basis of trade.
7. Explain the implications of uncertainty in managerial decision-making.
7.4 Explain how incentives can affect various relationships in an organization.
Required Unit Resources
Chapter 4: Extent (How Much) Decisions (ULO 7.4)
Chapter 21: Getting Employees to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 22: Getting Divisions to Work in the Firm’s Best Interests (ULO 7.4)
Chapter 23: Managing Vertical Relationships (ULO 7.4)
Unit Lesson
Lesson: Organizational Design and Incentives (ULO 7.4)
This lesson covers the topics introduced in this final unit.
The last unit’s topic on asymmetric information included a section on shirking. Recall that shirking is when
employees do not work hard because the managers are not able to monitor their performance (either because
of ability or cost). Another way to look at the problem of shirking is through the principal-agent problem. In the
principal-agent problem, the principal (typically a business owner) wants their agent (typically the employee)
to act on the principal’s behalf. The problem is that the agent often has different goals than the principal.
Incentives
Incentives are one way to correct shirking and solve the principal-agent problem. Incentives can be tied
directly to performance, such as commissions, as discussed in the last unit. Incentives can also be tied to
specific actions or the overall performance of the company. Basing incentives on company performance can
be dicey though. There are many factors outside the employees’ control that affect company performance.
The less tied incentives are to employee performance, the less likely the incentives will be to promote the
desired performance. Still, tying incentives to company performance does help align the goals of the principal
and the agent.
UNIT VIII STUDY GUIDE
Organizational Design and Incentives
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As mentioned, employees may not have a lot of control over company performance, which can complicate
attempts to align principal and agent goals. This can be because of large outside influences (demand for the
product) or because of the nature of the job agents have. Perhaps agents have the information to promote the
principal’s goals but lack the decision-making authority to realize them. In cases like this, it is important for
principals to align decision-making power with those who have information.
One model for aligning goals and addressing the principal-agent problem is the franchise model. In a
franchise model, a parent company, or brand, franchises out the opportunity to open additional stores under
the brand name for a percentage of sales. If a brand opened company-owned stores, they would have to rely
on managers who may not be as motivated, or the job may attract unmotivated managers (recall the different
explanation for similar problems with moral hazard and adverse selection). With a franchise model, however,
the individual franchise owner is motivated to make the franchise a success, since that determines the profit.
When companies grow, they are often divided into different divisions. Incentives can be tricky in ensuring the
divisions are working toward the same goal. If the incentives are not structured correctly, the divisions may
make decisions that are best for the division but not best for the company.
Take for example a college admissions department and an academic department. The academic department
might be interested in producing quality graduates that will earn the school a good reputation. The academic
department can help realize those goals with stricter admissions standards. The admissions department,
however, might be interested in reducing admissions standards in order to admit as many people as possible
(or at least enough to meet departmental goals). Stricter admissions standards get in the way of admissions.
Having too many, low quality students in a program can detract from the attention focused to turn the higher
quality students into reputable graduates who will help build the department’s reputation. Sharing information
and aligning the goals of the departments is key to getting both departments to act in the interest of the school
as a whole.
Sometimes there are exchanges between divisions in an organization. Tracking this and crediting each
division is important. Transfer pricing is the price of an intermediate good, made in-house, and then “sold” to
another division. Transfer pricing might be thought of most easily with manufacturing. When making a car, the
engine is built and then put into the frame. Since it is just the car that is ultimately sold at a price, crediting the
division that built the engine can be difficult. Obviously, the car would not be much good without the engine.
Determining the price for the engine, however, is difficult and often controversial between the divisions. The
engine division will want to be credited with a high price for the engine, but the division that built the frame will
want to “pay” a low price for the engine. Each division wants to appear as profitable as possible. Giving one
division an unfair price could hurt morale, and thus productivity, in that division. That would, obviously, hurt
the company overall.
Transfer pricing issues can be addressed by treating different divisions as profit centers or cost centers. Profit
centers are evaluated based on profit or revenue. Cost centers are evaluated based on costs. Using these
different centers and different goals, as long as the divisions are aligned to the proper center, their goals will
align with helping the overall organization be more successful.
Organizations can be ordered based on a variety of plans. Organizations might be organized by function,
such as production and sales. Organizations can also be organized by products or by geographic region. The
best organizational structure will depend on the type of firm and how they approach the market.
Vertical Relationships
Firms can also find profit potential by expanding operations vertically through their supply chain. This strategy
is known as a vertical relationship. For a simple example of this, consider a landlord, particularly one
constrained by rent control laws. The landlord may find him- or herself constrained in what he or she can
charge for rent. There are other services, however, that can be provided to tenants beyond just the living
space. A landlord might, for example, furnish the apartment for an extra fee. Firms can even use exclusions,
forcing buyers to purchase their additional product or service rather than purchasing from a competitor. A
similar approach is taken with movie theaters or ballparks who sell the tickets to the event and then also
require that if customers want to enjoy refreshments, they must do so at the concession stands operated by
the event.
ECO 6301, Economics for Managers 3
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Vertical relationships can also be used to manipulate realized profit. A firm may produce an early stage of a
product in a high tax area but transfer the production to another location with lower taxes for finalization. The
transfer can be done at a low price so that the high tax production does not produce much profit and then the
product is sold by the low tax production area with a higher profit realized thanks to the low transfer/purchase
price. The reverse can also be done where firms build in profit all along the production pipeline. This is known
as double marginalization. Of course, if the markups are too much then the price of the product in the market
will be too high.
Sometimes the incentives between links in the supply chain, for example between manufacturers and
retailers, come into conflict. Manufacturers might have an incentive to have the quality of their product
maintained and displayed but the retailer many not have quite the same concern. Have you ever been in a
store that sells high quality stereos and speakers? You might notice a special room set up to listen to the
speakers. This is by the design of the stereo and speaker producer, not necessarily the store. The purpose is
to provide an environment where you can really hear the quality of the higher priced stereos and speakers. In
exchange for providing the fancy displays, the manufacturers put minimum prices on their products wherever
they are sold. The purpose of these minimum prices is to prevent the fancy store from spending money on the
display only to have consumers come in, listen to the stereos and speakers, decide what they want, and go to
Walmart to buy it for a cheaper price.
Similarly, you generally will not see retailers engage in too much advertising. Advertising is mostly handled by
the producers of the product. A retailer advertising for a particular good may end up convincing consumers to
buy the product but not necessarily from their location.
Too much in the way of vertical relationships, however, can raise antitrust concerns. Strong vertical
relationships can have a negative effect on market competition, so many countries have antitrust laws
governing vertical relationships. In Europe, for example, Coke is prohibited from purchasing refrigerators in
their retail locations. The fear is that Coke owning the refrigerators will lead to the exclusion of other soft drink
producers being able to provide their product cold and ready to drink. So, vertical relationships can come with
much potential for firms, but they can also come with risks firms should be aware of before pursuing them.
A final word on vertical relationships—vertical relationships can be pursued through mergers. Simply merging
with another organization in a business’s supply chain does not always work out. In a free market, where
buyers and sellers are rational and have full information, the sellers would only accept a price equal to the
discounted stream of future profits. That means, all else equal, the best the purchasing firm could expect to
do is break even on the purchase. The potential for the merger to work out is based on some type of synergy
to be realized that makes the purchased company/asset more valuable for being part of the purchasing
company. Perhaps the smaller company will benefit from a larger distribution system already in place with the
purchasing company.
Suggested Unit Resources
Article: An Evaluation of Alternative Market-Based Transfer Prices (Optional)
This article further explores the topics covered in this unit.
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