652 PART • Information, Market Failure, and the Role of Government to Chapter 11, where we discussed transfer pricing in the vertically integrated firm—that is, how the firm sets prices for parts and components that upstream divisions supply to downstream divisions Here we will examine problems that stem from asymmetric information Asymmetric Information and Incentive Design in the Integrated Firm In an integrated firm, division managers are likely to have better information about their different operating costs and production potential than central management has This asymmetric information causes two problems How can central management elicit accurate information about divisional operating costs and production potential from divisional managers? This information is important because the inputs into some divisions may be the outputs of other divisions, because deliveries must be scheduled to customers, and because prices cannot be set without knowing overall production capacity and costs What reward or incentive structure should central management use to encourage divisional managers to produce as efficiently as possible? Should they be given bonuses based on how much they produce? If so, how should they be structured? To understand these problems, consider a firm with several plants that all produce the same product Each plant’s manager has much better information about its production capacity than central management has In order to avoid bottlenecks and to schedule deliveries reliably, central management wants to learn more about how much each plant can produce It also wants each plant to produce as much as possible Let’s examine ways in which central management can obtain the information it wants while also encouraging plant managers to run the plants as efficiently as possible One way is to give plant managers bonuses based on either the total output of their plant or its operating profit Although this approach would encourage managers to maximize output, it would penalize managers whose plants have higher costs and lower capacity Even if these plants produced efficiently, their output and operating profit—and thus their bonuses—would be lower than those of plants with lower costs and higher capacities Plant managers would also have no incentive to obtain and reveal accurate information about cost and capacity A second way is to ask managers about their costs and capacities and then base bonuses on how well they relative to their answers For example, each manager might be asked how much his or her plant can produce each year Then at the end of the year, the manager receives a bonus based on how close the plant’s output was to this target For example, if the manager’s estimate of the feasible production level is Qf , the annual bonus in dollars, B, might be B = 10,000 - 5(Qf - Q) (17.3) where Q is the plant’s actual output, 10,000 is the bonus when output is at capacity, and is a factor chosen to reduce the bonus if Q is below Qf Under this scheme, however, managers would have an incentive to underestimate capacity By claiming capacities below what they know to be true, they