If it’s worth doing..
Eliminating pollution. Earning straight As. Being completely organized Cleaning your apartment until it sparkles. Making automobiles completely safe. Making airplanes fully secure against terrorist attacks. All of these are worthwhile goals, right? Well, they are until you consider the costs of actually achieving them. The heading for this post is of course, a play on the old saying, “If it’s worth doing, it’s worth doing to the best of your ability.” Economics suggests, however, that this is not a sensible guideline At some point. the gains from doing something even better will not be worth the cost It will make more sense to stop short of perfection.
As more resources are dedicated to an activity, the marginal improvements (benefits) will become smaller and smaller, while the marginal costs will rise. The optimal time and effort put into the activity will be achieved at Q2, and this will nearly always be well below one’s best effort. Note that inef-ficiency results when either too little (for example, Q,) or too much (for example, Q,) time and effort are put into the activity.
Do you make decisions this way? Last time you cleaned your car or apartment, why did you decide to leave some things undone? Once the most important areas were clean, you likely began to slup over other areas (like on top of the refrigerator or under the bed), figuring that the benefits of cleaning these areas were not worth the cost. Very few people live in a perfectly organized and clean house, wash their hands enough to prevent all colds, brush their teeth long enough to prevent all cavities, or make their home as Fort Knox. They recognize that the benefit of perfection in these, and many other areas, is simply not worth the cost.
Economics is about trade-offs; it is possible to pursue even worthy activities beyond the level that is consistent with economic efficiency. People seem to be more aware of this in their personal decision making than when evaluating public policy. It is not uncommon to hear people say things like, “We ought to eliminate all pollution” or “No price is too high to save a life.”
Incentives, cooperation and the nature of the firm (2)
The firm can reduce many of the transaction costs associated with contracting by using team production. Team production, however, comes with another set of problems. Team members – the employees working for the firm. – must be monitored and given incentives to avoid shirking, or working at less than the expected rate of productivity. Taking long work breaks, paying more attention to their own convenience than to work results, and wasting time when diligence is called for are examples of shirking. A worker will shirk more when the costs of doing so are shifted to other team members, including the owners of the firm. Hired managers, even including those at the top, must be monitored and given incentives to avoid shirking.
Imperfect monitoring and imperfect incentives are a problem with team production. It is part of a larger class of what economists call principal-agent problems. A person taking a car to an auto mechanic confronts this problem. The mechanic wants to get the job done quickly and make as much money on it as possible. The car owner wants to get the job done quickly also, but wants the problem fixed in a lasting way, at the lowest possible cost. Because the mechanic typically knows far more about the job than the customer, it is hard for the customer to monitor the mechanic’s work. There is a possibility, therefore, that the mechanic may charge a large amount for a “quick fix” that will not last.
The owner of a firm is in a similar situation. It is often difficult to monitor the performance of individual employees and motivate them in a way that will encourage high productivity. Nonetheless, the ability of the firm to use resources effectively and succeed in a competitive market depends crucially upon resolving these problems. To keep costs low and the value of output high, a firm must discover and use an incentive structure that motivates managers and workers, and discourage5 shirking. The problem extends all the way to the top.
Even top-level executives hired to manage a firm do not have the same objectives as owners – who care mainly about profit maximization – unless, of course, the managers are the owners. So the judgments of executives, too, are influenced by what is in their personal best interests. They want perks, personal job security, and other benefits that may not be consistent with profit maximization for the firm. The problem becomes more serious as firms grow larger and acquire more managers and employees. Ultimately, it is the job of the owners, as residual claimants, to develop an incentive structure to minimize the principal-agent problem. For the owner, the saying “the buck stops here” always applies.