Our discussion of rational behavior can be used to understand one of the biggest policy issues of our time, welfare reform. We can do this by assuming that welfare recipients are tolerably rational.
So much of the public discussions about welfare programs, especially cuts in them, assumes that since Congress has the authority to change the programs, it can alter the programs any way it wishes without creating problems. However, as we can easily see, Congress is in something of an economic, if not political, bind on welfare relief, given how incentives change when the program is adjusted. The basic problem is that the practice of scaling down welfare benefits as earned income rises creates an implicit marginal tax on additional earned income that discourages the poor from working. Why not lower the implicit marginal tax rate?
Our graphic analysis suggests that there may be economic as well as altruistic limits to the government’s ability to transfer income from the rich to the poor. As more and more income is allocated to the poor, either the guaranteed income or break -- even income level must go up. If only the guaranteed income level is raised, the implicit marginal tax rate facing the poor increases. If that problem is avoided by raising the break -- even income level, poverty relief will cover more people, and the taxes paid by the remaining workers will go up. Increased aid to the poor thus should have three consequences. A higher explicit tax burden will fall on fewer taxpayers. Because of this burden, higher -- income groups will have less incentive to work, and lower -- income groups, because of the higher implicit tax rate, will also be less inclined to work.
MANAGER’S CORNER: The Last-Period Problem
Much of this chapter has been concerned with how people behave rationally. Here, we introduce “opportunistic behavior” as a form of rational behavior that people in business will want to protect themselves from. We suggest ways different parties to business deals can take advantage of other parties and how managers can structure their organizational and pay policies to minimize what we call “opportunistic behavior.” More specifically, this section is concerned with how an announced end to a business relationship can inspire opportunistic behavior. Its goal is, however, constructive, structuring business deals – and the embedded incentives -- in order to maximize the durability and profitability of the deals. To do that, business relationships must be ongoing, or have no fixed end, to the extent possible. Having a fixed termination date can encourage opportunistic behavior, which can reduce firm revenues and profits. That is to say, a reputation for continuing in business has economic value, which explains why managers work hard to create such a reputation.
The basic problem is that during the last period of any business relationship, there is no penalty for cheating, which implies maximum incentive to cheat. As a consequence, cheating on deals in the last period is more likely than at any other time in the relationship.
Consider a simple business deal. Suppose that you want a thousand widgets of a given quality delivered every month, starting with January and continuing through December, and that you have agreed to make a fixed payment to the supplier when the delivery is made. If you discover after you have made payment that your supplier sent fewer than a thousand units or sent the requisite thousand units but of inferior quality, you can simply withhold future checks until the supplier makes good on his or her end of the bargain. Indeed, you can terminate the yearlong contract, which can impose a substantial penalty for any cheating early in the contract. Knowing that, the supplier will tend to have a strong incentive early on in the contract period to do what he or she has agreed to do.
However, the supplier’s incentive to uphold his or her end of the bargain begins to fade as the year unfolds, for the simple reason that there is less of a penalty -- in terms of what is lost from your ending the working relationship -- that you can impose. The supplier might go so far as to reason that during the last period (December), the penalty is very low, if not zero. The supplier can cut the quantity or quality of the widgets delivered during December and then can take the check before you know what has been done. The biggest fear the supplier has is that you might inspect the shipment before handing over the final check. You may be able to get the supplier to increase the quantity or quality somewhat with inspection, but you should expect him or her to be somewhat more difficult to deal with. And you should not expect the same level of performance or quality.
The problem is that you have lost a great deal of your bargaining power during that last month, and that is the source of what we call and mean by the last-period (or end -- period) problem, meaning the costs that can be expected to be incurred from opportunistic behavior when the end of a working relationship approaches. It is a problem, however, that can be mitigated in several ways. The simplest and perhaps most common way is by maintaining continuing relationships. If you constantly jump from one supplier to another, you might save a few bucks in terms of the quoted prices, but
you might also raise your costs in terms of unfulfilled promises by suppliers during the last period of their association with you. “Working relationships,” in other words, have an economic value apart from what the relationship actually involves, for example, the delivery of so many widgets. This is one important reason businesses spend so much time cultivating and maintaining their relationships and why they may stick with suppliers and customers through temporary difficulties.
Solutions to the Last-Period Problem
Nothing works to solve the last-period problem, however, like success. The more successful a firm is -- the greater the rate of growth for the firm and its industry -- the more likely others will recognize that the firm will continue in business for sometime into the future. The opposite is also true -- failure can feed on itself as suppliers, buyers, and workers begin to think that the last period is near. Firms understand these facts of business life. As a consequence, executives tend to stress their successes and downplay their failures. Their intent may not be totally unethical, given how bad business news can cause the news to get worse. Outsiders understand these tendencies. As a consequence, many investors pay special attention to whether executives are buying or selling their stock in their companies. The executives may have access to (accurate) insider information that is not being distributed to the public.
Another simple way of dealing with the last-period problem in new relationships is to leave open the prospect of future business, in which case the potential penalty is elevated (in a probabilistic sense) in the mind of the supplier. When there is no prospect of future business, the expected cost from cheating is what can be lost during the last period. When there is some prospect of future business, the cost is greater, equal to the cost that can be imposed during the last period plus the cost (discounted by the probability that it will be incurred) incorporated in the loss of future business.
When dealing with remodeling or advertising firms, for instance, you can devise a contract for a specified period, but you can suggest, or intimate, in a variety of creative ways, that if the work is done as promised and there are no problems, you might extend the contract or expand the scope of the relationship. In the case of the remodeling firm, you might point out other repairs in the office that you are thinking of having done. In the case of the advertising firm, you might suggest that there are other ad campaigns for other products and services that you are considering.
You should, therefore, be able to secure somewhat better compliance with your supplier during the last period of the contract, and how much the compliance is improved can be related to just how well you can convince your supplier that you mean business (and a lot of it) for some time into the future. However, we are not suggesting that you should outright lie about uncertain future business. The problem with lying is that it can, when discovered, undercut the value of your suggestions of further business and bring back to life the last-period problem. You need, in other words, to be prepared to extend, from time to time (if not always), working relationships when in fact they work the way you want them to work.
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