Resource Allocation Auctions Within Firms

There is growing interest in the use of markets within firms. Proponents have noted that markets are a simple and efficient mechanism for allocating resources in economies in which information is dispersed. In contrast to the use of markets in the broader economy, the efficiency of an internal market is determined in large part by the endogenous contractual incentives provided to the participating, privately informed agents. In this paper, we study the optimal design of managerial incentives when resources are allocated by an internal auction market, as well as the efficiency of the resulting resource allocations. We show that the internal auction market can achieve first-best resource allocations and decisions, but only at an excessive cost in compensation payments. We then identify conditions under which the internal auction market and associated optimal incentive contracts achieve the benchmark second-best outcome as determined using a direct revelation mechanism. The advantage of the auction is that it is easier to implement than the direct revelation mechanism. When the internal auction mechanism is unable to achieve second-best, we characterize the factors that determine the magnitude of the shortfall. Overall, our results speak to the robust performance of relatively simple market mechanisms and associated incentive systems in resolving resource allocation problems within firms

Conservatism correction for the market-to-book ratio and Tobin’s q

We decompose the market-to-book ratio into two additive components: a conservatism correction factor and a future-to-book ratio. The conservatism correction factor exceeds the benchmark value of one whenever the accounting for past transactions has been subject to an (unconditional) conservatism bias. The observed history of a firm's past investments allows us to calculate the magnitude of its conservatism correction factor, resulting in an average value that is about two-thirds of the overall market-to-book ratio. We demonstrate that our measure of Tobin's q, obtained as the market-to-book ratio divided by the conservatism correction factor, has greater explanatory power in predicting future investments than the market-to-book ratio by itself. Our model analysis derives a number of structural properties of the conservatism correction factor, including its sensitivity to growth in past investments, the percentage of investments in intangibles, and the firm's cost of capital. We provide empirical support for these hypothesized structural properties

The Value of Correlated Signals in Agencies

We analyze optimal correlation levels in information technologies when multiple signals are available as contracting mechanisms within the principal-agent paradigm. We identify sufficient conditions ensuring that uniformly lower-correlation functions (in action levels) are preferred, as well as (mutually disjoint) sufficient conditions for a higher-correlation function to be preferred. We also show that if correlation levels are invariant in the agent's action choice, the preference is for negative correlation, but not perfectly negative correlation. We generalize techniques originally used for proving Blackwell's theorem and show that our results extend to the decision context as well.

Objective versus Subjective Performance Indicators in Incentive Contracts ∗ (preliminary and incomplete)

Theoretical and empirical studies on managerial incentives have increasingly pointed to the role of subjective, non-verifiable performance indicators. Murphy and Oyer (2003) note that nearly two-thirds of the companies in their sample base bonuses, in part, on subjective assessments of individual performance. In contrast to the explici