Monitoring, Incentives, and Cooperation: The Strategy Behind the Organizational Game

Zenichi Shishido

Berkeley Olin Program in Law & Economics, Working Paper Series from Berkeley Olin Program in Law & Economics

Abstract: The simple view of joint ventures and venture businesses is that both partners will cooperate to maximize their equity value. In reality, however, there is no guaranty that each partner always behaves to maximize the value of the equity, because partners may have conflicting interests. The unpredictability that the fellow partner will not cooperate will distort your own incentive to cooperate. The combination of equity and monitoring contracts are used to reduce this unpredictability. The goal of this paper is to describe the game between the partners and to outline good business planning. The straightforward way to reduce the unpredictablity about cooperation of your partner is to obtain the residual right of the corporation. In this scenario you could exclude your partner if he fails to cooperate. The problem will not, however, be solved because a substitute for your partner is usually costly in joint ventures and venture businesses. The threat of exclusion will distort your partners incentive to cooperate. To encourage cooperation, you must minimize both your own unpredictability and your partner's unpredictability. Partners use "monitoring contracts" such as vetoes, to modify the situation where one partner has complete residual right and to share the unpredictability. The optimal way of sharing the unpredictability depends on which partner provides more critical human capital, how strong the bargaining power of each partner is, and how the reputational bond will work for each partner. In this paper, I describe the organizational game of allocating the unpredictability to cooperate. The game is played as follows. The relative value of human capital, the bargaining power of each partner, and the reputational bond are given. The partners negociate the mixture of equity sharing and monitoring contracts under the given conditions. Each partner tends to minimize his own unpredictability too much and, as a consequence, does not maximize his long-term interest. I conclude by describing how the outcome of negotiation could be improved.

Date: 1998-10-29
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