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The Groves Scheme, Profit Sharing and Moral Hazard

Author

Listed:
  • Susan I. Cohen

    (Washington University, St. Louis)

  • Martin Loeb

    (University of Maryland)

Abstract

Considered in this paper is the problem of intrafirm resource allocation. Two incentive schemes, the Groves scheme and profit sharing, have been presented in the literature as ways of dealing with this problem under conditions of asymmetric information. In the absence of effort aversion by division managers, it has been shown that truth-telling forms a dominant strategy equilibrium using the Groves scheme and a Nash equilibrium using profit sharing. The analysis in this paper allows for the problem of moral hazard (effort aversion) as well as the problem of asymmetric information. It is shown that for a deterministic case in which the headquarters seeks to maximize a measure of total profits gross of divisional rewards, a reinterpreted Groves scheme will yield a dominant equilibrium. At this equilibrium, the headquarters implicitly considers the division managers' effort levels as a cost to the firm. It is also shown that in the presence of moral hazard, profit sharing will not generally yield a Nash equilibrium. Furthermore, profit sharing may encourage the transmission of misinformation by a division manager so as to change the division's capital allocation and reduce the effort level subsequently selected by the manager.

Suggested Citation

  • Susan I. Cohen & Martin Loeb, 1984. "The Groves Scheme, Profit Sharing and Moral Hazard," Management Science, INFORMS, vol. 30(1), pages 20-24, January.
  • Handle: RePEc:inm:ormnsc:v:30:y:1984:i:1:p:20-24
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    File URL: http://dx.doi.org/10.1287/mnsc.30.1.20
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    Citations

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    Cited by:

    1. Kirstein, Roland, 2004. "Anti-Teilen in Teams," CSLE Discussion Paper Series 2004-04, Saarland University, CSLE - Center for the Study of Law and Economics.
    2. Hofmann, Christian & Pfeiffer, Thomas, 2001. "Investitionsbudgetierung und Anreizprobleme: Ist der Groves-Mechanismus nur third-best? Zur Effizienz des Groves-Budgetierungsmechanismus," Hannover Economic Papers (HEP) dp-249, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    3. Li, Shu-Hsing & Balachandran, Kashi R., 1997. "Optimal transfer pricing schemes for work averse division managers with private information," European Journal of Operational Research, Elsevier, vol. 98(1), pages 138-153, April.
    4. Feldmann, Martin & Müller, Stephanie, 2003. "An incentive scheme for true information providing in Supply Chains," Omega, Elsevier, vol. 31(2), pages 63-73, April.
    5. Hoang, Daniel & Gatzer, Sebastian & Ruckes, Martin E., 2018. "The economics of capital allocation in firms: Evidence from internal capital markets," Working Paper Series in Economics 115, Karlsruhe Institute of Technology (KIT), Department of Economics and Business Engineering.
    6. Gatzer, Sebastian & Hoang, Daniel & Ruckes, Martin, 2015. "Internal Capital Markets and Diversified Firms: Theory and Practice," EconStor Preprints 169432, ZBW - German National Library of Economics.
    7. Christian Lohmann & Sandro Lombardo, 2014. "Resource allocation within a budgeting game: truthful reporting as the dominant strategy under collusion," Metrika: International Journal for Theoretical and Applied Statistics, Springer, vol. 25(1), pages 33-54, September.

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