(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 677

652 PART 4 • Information, Market Failure, and the Role of Government
to Chapter 11, where we discussed transfer pricing in the vertically integrated
firm—that is, how the firm sets prices for parts and components that upstream
divisions supply to downstream divisions. Here we will examine problems that
stem from asymmetric information.

Asymmetric Information and Incentive Design
in the Integrated Firm
In an integrated firm, division managers are likely to have better information
about their different operating costs and production potential than central management has. This asymmetric information causes two problems.
1. How can central management elicit accurate information about divisional
operating costs and production potential from divisional managers? This
information is important because the inputs into some divisions may be
the outputs of other divisions, because deliveries must be scheduled to
customers, and because prices cannot be set without knowing overall
production capacity and costs.
2. What reward or incentive structure should central management use to
encourage divisional managers to produce as efficiently as possible?
Should they be given bonuses based on how much they produce? If so,
how should they be structured?
To understand these problems, consider a firm with several plants that all
produce the same product. Each plant’s manager has much better information
about its production capacity than central management has. In order to avoid
bottlenecks and to schedule deliveries reliably, central management wants to
learn more about how much each plant can produce. It also wants each plant to
produce as much as possible. Let’s examine ways in which central management
can obtain the information it wants while also encouraging plant managers to
run the plants as efficiently as possible.
One way is to give plant managers bonuses based on either the total output of their plant or its operating profit. Although this approach would
encourage managers to maximize output, it would penalize managers whose
plants have higher costs and lower capacity. Even if these plants produced

efficiently, their output and operating profit—and thus their bonuses—would
be lower than those of plants with lower costs and higher capacities. Plant
managers would also have no incentive to obtain and reveal accurate information about cost and capacity.
A second way is to ask managers about their costs and capacities and then
base bonuses on how well they do relative to their answers. For example,
each manager might be asked how much his or her plant can produce each
year. Then at the end of the year, the manager receives a bonus based on
how close the plant’s output was to this target. For example, if the manager’s
estimate of the feasible production level is Qf , the annual bonus in dollars, B,
might be
B = 10,000 - .5(Qf - Q)

(17.3)

where Q is the plant’s actual output, 10,000 is the bonus when output is at capacity, and .5 is a factor chosen to reduce the bonus if Q is below Qf .
Under this scheme, however, managers would have an incentive to underestimate capacity. By claiming capacities below what they know to be true, they