Marina Halac, Columbia University, and Pierre Yared, Columbia University and NBER

Commitment vs. Flexibility with Costly Verification

Halac and Yared introduce costly verification into a general delegation framework. A principal faces an agent who is better informed about the efficient action but biased towards higher actions. An audit verifies the agent's information, but is costly. The principal chooses a permissible action set as a function of the audit decision and result. The researchers show that if the audit cost is small enough, a threshold with an escape clause (TEC) is optimal: the agent can select any action up to a threshold, or request audit and the efficient action if the threshold is sufficiently binding. For higher audit costs, the principal may instead prefer auditing only intermediate actions. However, if the principal cannot commit to inefficient allocations following the audit decision and result, TEC is always optimal. These results provide a theoretical foundation for the use of TEC in practice, including in capital budgeting in organizations, fiscal policy, and consumption-savings problems.

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Alan M. Benson, the University of Minnesota - Twin Cities; Danielle Li, Harvard University; and Kelly Shue, the University of Chicago and NBER

Can Promotion Tournaments Produce Bad Managers? Evidence of the "Peter Principle"

The best worker is not always the best candidate for manager. In these cases, do firms promote the best potential manager or the best worker in their current job? Using microdata on the performance of sales workers at 214 firms, Benson, Li, and Shue find evidence consistent with the Peter Principle: firms prioritize current job performance when making promotion decisions at the expense of other observable characteristics that better predict managerial performance. The researchers estimate that the costs of managerial mismatch are substantial, suggesting that firms make inefficient promotion decisions or that the incentive benefits of emphasizing current performance is also high.

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Wouter Dessein, Columbia University, and Richard Holden, the University of New South Wales

Organizations with Power-Hungry Agents

Dessein and Holden analyze a model of hierarchies in organizations where neither decisions themselves nor the delegation of decisions are contractible, and where power-hungry agents derive a private benefit from making decisions. Agents are probabilistically informed about the optimal action and maximize their private benefits as well as the payoffs of the activities assigned to them. Lower-level managers are more specialized and therefore internalize fewer externalities. The researchers study delegation decisions and optimal organizational design in this environment. A designer may remove intermediate layers of the hierarchy (eliminate middle managers) or de-integrate an organization by removing top layers (eliminate top managers). The researchers show that stronger preferences for power result in smaller, more de-integrated hierarchies. Their key insight is that hoarding of decision rights is especially severe at the top of the hierarchy. As a result, even a top manager who is a better stand-alone decision-maker than the middle and lower-level managers below him, may add negative value to a hierarchy. In contrast to standard delegation models, the uncertainty surrounding decisions and the magnitude of incentive conflicts of lower-level managers have a non-monotonic impact on the value of top and middle managers.

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Nicholas Bloom, Stanford University and NBER; Erik Brynjolfsson, MIT and NBER; Lucia Foster and Ron S. Jarmin, Bureau of the Census; Megha Patnaik, Stanford University; Itay Saporta Eksten, Tel Aviv University; and John Van Reenen, MIT and NBER

What Drives Differences in Management?

This paper analyzes a recent Census Bureau survey of "structured" management practices in over 30,000 U.S. plants. Analyzing these data reveals enormous variation in management practices across plants, with 40 percent of this variation being across plants within the same firm. The management index accounts for just under a fifth of the spread of TFP between the 90th and 10th percentiles, a similar fraction to that explained by R&D and over twice as much as explained by IT. Bloom, Brynjolfsson, Foster, Jarmin, Patnaik, Eksten, and Van Reenen find evidence for four causal "drivers" of management practices: product market competition (e.g. the Lerner index, exchange rate shocks), state business environment (as proxied by "Right to Work" laws), learning spillovers (e.g. proximity to "Million Dollar Plant" openings) and human capital (e.g. proximity to land grant colleges). Collectively these drivers account for about a third of the dispersion of management, suggesting the need to draw upon a wider range of theories to explain the remaining variation.

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Heikki Rantakari, the University of Rochester

Relational Influence

Rantakari studies how an uninformed principal elicits non-contractible recommendations from a privately informed agent regarding the quality of projects. The agent is biased in favor of implementation and no credible communication is possible in a one-shot setting. In a repeated setting, the fear of losing future influence can sustain informative communication, but the agent's willingness to remain truthful depends on the extent to which he expects the principal to listen to him. In a stationary equilibrium, the principal always implements mediocre projects at a sub-optimally high frequency to reward honesty, while she may either favor or discriminate against high quality projects. In a non-stationary equilibrium, the principal will further condition the agent's future influence on today's proposals, with the admission of mediocre alternatives rewarded with increased future influence while rejections of high-quality proposals are further punished by lowering the agent's future influence.

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Avi Goldfarb and Joshua Gans,the University of Toronto and NBER, and Mara Lederman, the University of Toronto

Exit, Tweets and Loyalty

At the heart of economics is the belief that markets discipline firms for poor performance. However, in his famous book Exit, Voice, and Loyalty, Hirschman highlights an alternative mechanism that has received considerably less attention: voice. Hirschman argues that, rather than withdrawing demand from a firm, consumers may choose to communicate their dissatisfaction to the firm. In this paper, Goldfarb, Gans, and Lederman develop a formal model of voice as the equilibrium of a relational contract between firms and consumers. Their model predicts that voice is more likely to emerge in concentrated markets, thus resolving a key source of ambiguity in Hirschman's original formulation. Empirically, authors estimate the relationship between quality, voice and market structure. Combining data on tweets about major U.S. airlines with data on airlines' daily on-time performance and market structure, they document that the volume of tweets increases in response to a deterioration in on-time performance and that this relationship is stronger when an airline operates a greater share of flights in a given market. In addition, Goldfarb, Gans, and Lederman find that airlines are more likely to respond to tweets in these markets. Our findings indicate that voice is an important mechanism that consumers use to respond to quality deterioration and that its use varies increases with market concentration.

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Rocco Macchiavello, University of Warwick, and Josepa Miquel-Florensa, Toulouse School of Economics

Vertical Integration and Relational Contracts in the Costa Rica Coffee Chain

Can long-term relationships between firms replicate the allocation of resources achieved by integration? Macchiavello and Miquel-Florensa answer this question in the context of the Costa Rica coffee chain, an environment in which trade occurs across a rich variety of organizational forms: integrated firms, long-term relationships between firms, and market transactions. The researchers examine firm-level correlates of these organizational forms and how organizational forms respond to exogenous changes in supply and unanticipated swings in market conditions. They find that supplier and buyer characteristics associated with integration also correlate with the use of long-term relationships on the sample of non-integrated firms. Long-term relationships between firms respond to shocks like integrated trade and differently from nonrepeated trade between firms. Integration and long-term relationships between firms differ in exclusivity: integrated suppliers only sell within the integrated chain, while independent suppliers rarely sell only to one buyer. Relative to long-term relationships, integration allows parties to trade larger volumes but makes it harder to sustain relationships with independent suppliers and buyers. The evidence supports models in which firms boundaries alter temptations to renege on relational contracts and, consequently, the allocation of resources.

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Christopher Hansman and Matthieu Teachout, Columbia University; Jonas Hjort, Columbia University and NBER; and Gianmarco León, Universitat Pompeu Fabra

Vertical Integration, Supplier Behavior, and Quality Upgrading among Exporters

This paper studies the relationship between backward vertical integration and output quality. The setting is a large manufacturing sector in Peru where plants produce a vertically differentiated but otherwise homogeneous product for export: fishmeal. Hansman, Hjort, León, and Teachout link customs data on each shipment’s value and quality grade to plant level production data, transaction level data on supplies from integrated and independent suppliers (fishing boats), and GPS measures of supplier behavior. They first document a highly robust correlation between the quality grade of a firm's exports and the share of its inputs that comes from vertically integrated suppliers at the time of production. They then show that firms adopt a strategy of sourcing more of their inputs from integrated suppliers when faced with firm-specific high-quality demand shocks. Guided by a conceptual framework in which the worse outside option of supplier managers that are integrated with downstream buyers lowers their incentive to “shirk” on input quality, the researchers explore why output quality is higher when inputs come from integrated suppliers. Exploiting changes in supplier status and exogenous variation in production conditions, they show that a given supplier supplying a given plant on average delivers smaller batches of higher quality inputs (i.e., fresher fish) when integrated, and does so comparatively more (i) when there is a need for the downstream firm to produce high quality output, and (ii) when plankton conditions makes it difficult to produce high quality inputs.

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Enghin Atalay and Jialin Li, the University of Chicago, and Ali Hortaçsu and Chad Syverson, the University of Chicago and NBER

How Wide Is the Firm Border?

Atalay, Hortaçsu, Li, and Syverson quantify the transaction costs that firms face when participating in intermediate goods markets. To do so, they examine the shipment behavior of tens of thousands of establishments that produce and distribute a variety of products throughout the goods-producing sector. The researchers' main analysis relates the frequency of shipments across pairs of sending establishments and destination zip codes to the proportion of establishments in the destination which share ownership with the sender. These regressions reveal that the firm boundary is notably wide: An additional downstream establishment which shares ownership with the sender has an equivalent effect on trade intensity as a 30 percent reduction in distance between sender and destination. A calibration of a multisector general equilibrium trade model demonstrates that these transaction costs also have discernible economy-wide implications.

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Miguel Antón, IESE Business School; Florian Ederer, Yale University; Mireia Giné, WRDS, the University of Pennsylvania; and Martin C. Schmalz, the University of Michigan

Common Ownership, Competition, and Top Management Incentives

Antén, Ederer, Giné, and Schmalz show theoretically and empirically that executives are paid less for their own firm's performance and more for their rivals' performance if an industry's firms are more commonly owned by the same set of investors. Higher common ownership also leads to higher unconditional total pay. The researchers exploit quasi-exogenous variation in common ownership from a mutual fund trading scandal to support a causal interpretation. These findings challenge conventional assumptions in the corporate finance literature about the objective function of the firm.