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Notes on Exploration and Exploitation

Questi appunti forniscono alcuni dei concetti chiave del corso Introduction to the Modern Firm. Essi si focalizzano sulle strategie aziendali di "exploration and exploitation" con i relativi pro e contro. Inoltre, vi sono presenti delle possibili domande d'esame con risposte specifiche e concrete sui contenuti principali del corso.

Esame di Introduction to the Modern Firm 2 docente Prof. M. Warglien




via “skunk works” model. The term refers to the working on top secret projects,

therefore the teams are isolated completely by the organization.

Nevertheless, the best way to solve the multitasking problem is to employ the use of

the “high commitment human resource management”, which is about creating a

culture and a related design that emphasizes the values such as collaboration,

cooperation and mutual respect. The key elements of the latter are guaranteed

employment, self-managed teams, hard work, premium compensations, extensive

socialisation and constant training for employees and transparency of information. The

integrating mechanisms are mutual adjustment and social pressure.

Define the problem of observability and how it relates to moral hazard.


At first, we have to explain the problem of motivation in order to understand the

observability issue. People are selfish and they tend to pursue their own interests

without taking into account the impact that their actions have over the society, in this

case the firm. This problem rises, as a matter of fact, that the employee doesn’t

produce something that directly he would consume. Moreover, he doesn’t directly

receive all the benefits born from his labor, because these accrue to the firm and the

agent gains only a small fraction. Therefore, he becomes reluctant to work as hard as

if he would receive the full fruits of his labor. So, the motivational problem arises, the

principal has to find a way to incentivize employees to work on her behalf rather than

their own self-interest. Incentives will be based on the performance measures of the

agent actions, and they will determine the strength of effort required. The stronger the

incentives, the harder people will work, mathematically we can describe this

relationship as a monotonic function. The issue, now, is to determine the performance

measures and the problem of observability arises. Ideally, the principal and the agent

would sign a contract where the appropriate behavior is specified in advance, so that

she could buy the exact amount of effort, and give the perfect incentives. This

contract, in order to be valid, has to be enforceable by a third party but it is almost

impossible to monitor directly the actions of the agent so the principal has to accept to

monitor performance in an imperfect and unclear way. The most she can do is to

control the final results of the agent’s actions and to provide an incentive scheme, a

contract or compensation that rewards or punishes the performance of employees’

actions. Due to this impossibility to directly monitor actions, the agent has the

opportunity to act opportunistically since the performance is a function of his effort,

but also of other external variables, called noise, that blur the effective measurement

of the final results. For example, an employee might give very little effort to his work,

but thanks to pure luck his performance results very efficient. Hence, the problem of

observability leads to the moral hazard, due to the great information asymmetry

between the two parties. The moral hazard is the tendency of the informed party to

take certain actions to the transaction, which aren’t observable by the other party and

that affect negatively the benefits the latter would gain by the transaction.

In conclusion, the moral hazard is a direct consequence of the problem of

observability. Indeed, the agent is led to act opportunistically, namely pursue its self-

interest, since his actions cannot be directly monitored and his performance is affected

by noise, factors that are out of his control. 2


Why if the agent is risk averse and performance reflects effort in a noisy way,

- the more pay is related to performance the more the principal will have to pay

for it.

Firstly, the simple agency theory describes the relation of a person the agent, who

acts of the behalf of another, namely the principal. The agency problem arises when

there is a gap between the result of the agent actions and his effort. This model is

based on two main assumptions – the agent is risk-averse, whereas the principal is

risk-neutral. This difference of approach to the risk requires the principal to pay

greater attention on the incentives she provides to the agent, because the strength of

the incentives will determine the strength on the effort given by the employees.

However, if the agent is risk-averse and performance is not clearly measurable, it is

better to provide weak incentives, otherwise the agent will bear too great risks, which

will result in a greater cost borne by the principal. In other words, it would be too

costly for the principal, to delegate such a responsibility to a risk-averse agent due to

the wide randomness of variables that affect performance.

Why stronger incentives (e.g. more variable pay) can be provided when

- performance measures are more accurate in reflecting agent’s effort (less


If performance is clearly measure, then, the incentives can be much stronger as the

effort provided. Indeed, the strength of the incentives determines the amount of effort

the agent will choose to provide. If performance measurement can be detailer, it

means that the contract is enforceable so the principal can describe the appropriate

behavior in advance and request the first-best level of effort, buying the exact amount

of labor. With such a contract, the principal has greater bargaining power because she

has the property rights to determine the right compensation to the employees either

to reward him or punish him if he has behaved inappropriately.

What are the selection effects of pay for performance?


Stronger incentives can be given to less risk-averse agents and the allocation of the

formers leads to the selection effect. The latter describes the tendency of abler worker

to be more attractive by stronger incentives. Agent can personally choose the degree

of risk to bear. A concrete example is given by the companies Lincoln Electric and

Lazear, which moved their performance pay from fixed salary to piece rate. The piece

rate is a strong incentive for better performance. The latter raised greatly the

profitability of both, thanks also to the ability to make piece rates credible, by

increasing the workers’ trust to the organization through several policies. Moreover,

we can say that who has a higher salary is abler to take risks.

What is the principle of informativeness in incentive design?


The principle of informativeness states that the principle has to rely upon informative

information, which are based on accurate performance measure, in order to determine

the right incentives to the different tasks and balance the trade-off between the

benefits borne by extra effort provided and the costs of the risk borne by the agent.

Informative information allows to skim the random variables that affect performance

and that will, consequently determine the performance pay of agents.

An example is given by BP, where the performance pay was based on real randomness

since the workers’ performance was greatly affected by the year variations on crude

oil prices. Therefore, BP decided to introduce the “self-help” in performance pay. A 3


method that distinguished the measures for actual earning and the one for oil price, in

order to give a better indication of what people in the firm actually did.

What is the multitasking problem? Why, if one task has more accurate

- measures than another, this may induce a “distorted mix” of activity by the


The multitasking problem is the issue related to the provision of incentives when the

agent has to spend attention and effort over more tasks. The solution to solve this

problem is to give an appropriate balance of incentives among tasks, in order to

equally incentivize the agent to provide equal effort to the diverse tasks he has to

purse. Otherwise, if the incentives are stronger on one activity over another, the agent

will by tempt to provide effort only on the best measured activity, undersupplying the

other even is both activities are important for the principal. Therefore, when the agent

cares about how time is divided among tasks (doing more of one will still increase the

costs of doing more of another), unless the incentives are appropriately balances, the

agent will overemphasize the better-rewarded activity scarifying the other.

Do men and women differ in their preferences for competition? How does it

- impact on economic issues?

Yes, they do. An experiment over 24 people, equally divided b/w men and women, has

shown that women tend to underestimate their abilities and to shy away from

competition. They result more risk-averse than men. On the other side, men

overestimate their abilities and they are largely affected by biases, implying a

misallocation of talents. The experiment focused on how the different groups reacted

to two diverse incentives – piece rated vs tournaments – applied to a gender-neutral

task such as adding up sets of 5 two-digits numbers in 5 minutes.

The piece rate rewarded individually, independently by the others’ performance.

Whereas, the tournament rewarded only the winner of the group, giving a 4 times

higher pay than the payoffs of the piece rate, therefore, each group member had the

100/4 = 25 % to win.

At the end, members had chosen their personal reward. The result was that too many

men entered in the tournaments compared to women. 4 women out of 12 entered in

the tournament compared to the 9 men to entered.

In conclusion, it can be stated that tournaments aren’t perfect incentives, despite the

advantage of costs saving in acquiring information about employees, through the use

of selective effect. They don’t allocate talents effectively.

What are alternatives to monetary rewards?


The non-monetary rewards are more about the intrinsic motivation. The first is

organizational design, which is crucial in determining motivation. The organizational

structure should be organic and allow cross-functional communication in order to

share important information and knowledge among different departments. Moreover, if

teams are small, the performance measure will be detailer since people mutually

check their behavior. Further, small groups eliminate the free-riding problem, because

rewards are more narrowly shared. 4

QUESTIONS & NOTES CH 6 - WARGLIEN front-and-back

Organizational design is connected to the model. The manufacturing

and other support unit for production are thought as the back of the organization,

whereas, marketing and sale are the front, where the organization is abler in gaining

information about costumer’s desires and needs. The aim is to create a tight

communication among them, in order to increase the organizational core


Reputation is another form of non-monetary rewards and intrinsic motivation. The

latter increases the personal value in the internal labor market of each agent, if these

behave correctly. Indeed, reputation means trust and reliability, it affects positively,

moreover, the position of the organization.

At last, but not for importance there is the PARC model, which employs the “high

commitment human resource management.” It is tied to the organizational design and

it requires a culture that emphasises strong collaboration and cooperation among

team members. The organization ensures employment, transparency of information

and high socialization and training for employees in other to make more enjoyable the

work. What are the typical traits of the competitive model of supply chain

- management?

In the competitive model of supply chain management, there are multiple suppliers

and the focus is on price, therefore, suppliers are in competition for delivering the

cheapest product to the buyer. Moreover, contracts are specified and have short-term

horizon. Suppliers are perfect substitute, because they have to deliver standardized

components, information asymmetry is fully exploited buy the buyer to keep prices

low. The main disadvantage is the lack of quality and cooperation.

What are the purchase reverse auctions?


A reverse auction is a type of auction in which sellers bid for the prices at which they

are willing to sell their goods and services. In a regular auction, a seller puts up an

item and buyers place bids until the close of the auction, at which time the item is sold

to the highest bid. In a reverse auction, the buyer puts up a request for a

required good or service. Sellers then place bids for the amount they are willing to

be paid for the good or service, and at the end of the auction the seller with the lowest

amount wins.

What is the bullwhip effect? Provide at least two causes for such an effect.


The idea of the bullwhip effect is that demand oscillations increase has they move

backward to the supply chain starting from the final consumer. It is the unexpected

distortion of the supply chain due to demand variations, it implies some cost and has a

negative effect over the business’ performance such as inventory and service level

deterioration, late responds and increase cost of material and manpower. The main

causes of the bullwhip effect are forecast error, over reaction to backlogs, poor

communication among value chain activities and wrong strategic amplification of

inventories when resources are scare.

What is the difference between friendly and hostile acquisitions?


Acquisitions occurs when a firm buys another (target). The latter can be friendly or

hostile takeover. The first one occurs when there is the consensus of both parties. 5




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5 mesi fa

Corso di laurea: Corso di laurea in economics and management (corso in inglese)
A.A.: 2017-2018

I contenuti di questa pagina costituiscono rielaborazioni personali del Publisher beatrice_fontana di informazioni apprese con la frequenza delle lezioni di Introduction to the Modern Firm 2 e studio autonomo di eventuali libri di riferimento in preparazione dell'esame finale o della tesi. Non devono intendersi come materiale ufficiale dell'università Ca' Foscari Venezia - Unive o del prof Warglien Massimo.

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Altri appunti di Introduction to the modern firm 2

Key Issues faced by Modern Firms
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Perfect Competition, Price discrimination and Olygopoly (Main Concepts)
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