Reputation, Incentives, and Transaction Costs in Firms

Stanford University, Stanford CA

Investigators

Abstract

This proposal includes two separate projects that together contribute to understanding mechanisms that affect incentives in firms. The first project investigates how the market for reputations can affect incentives of firm owner/operators. This problem is different from the standard reputation literature that investigates individual reputations. The researcher will use his model of firm reputations as tradeable assets as the starting point. In that model the issue of incentives was not addressed and no welfare or policy implications could be analyzed. By extending the previous model to include moral hazard, some interesting results and conjectures arise. First, there is a relationship with the Career Concerns literature and the signaling literature that provides a useful benchmark. However, unlike in a simple career concerns model, the market for reputations will be able to provide incentives for agents in terminal stages of their career. In fact, the "strength" of career concern incentives that an agent faces when he is young is the same as the strength of incentives created by the market for reputations when he is old. Some conjectures, policy implications, extensions and future avenues for work are then outlined. The second project is concerned with the role of incentives and transaction costs with respect to the celebrated make-or-buy decision: should a component be produced in the firm or procured across the market? This question has received much attention since Coase's seminal paper and was followed up by Williamson's development of Transaction Cost Economics, and by the Property Rights approach developed by such researchers as Grossman, Hart, and Moore. The researcher proposes to contribute to this literature with a variant of a procurement model that he (together with Patrick Bajari) has recently developed. In that model, which is motivated and informed by stylized facts from the construction industry, a buyer needs to hire a seller that will deliver a custom made good (e.g., house, factory, space shuttle, etc.). The buyer must first incur a cost of providing a comprehensive design, and is faced with a trade-off between providing incentives and reducing ex post transaction costs due to costly renegotiation. This approach shows that weak incentives are preferred over strong incentives when a project is more complex. This proposal seems to indicate that applying the model to the make-or-buy procurement decision may help explain why internal production dominates market procurement when the product is more complex. This is consistent with some well known empirical work, and would provide foundations for Transaction Cost Economics. Directions in which this can be done are outlined.