 Then, we will discuss about one more concept associated with managerial economics, that is understanding the incentives, how incentive works and what is the role of incentive in the economy. The architecture of an organization comprises with three, if you look at three pillars. One is distribution of ownership, second one is incentive scheme and third one is the monitoring system. Our focus is on the incentive scheme. A positive incentive measure is an economical institutional measure designed to encourage the beneficial activity. Always the incentive works in a positive way, if there is incentive may be the economic agent put more efforts in order to reach the goal or reach the objective. The main reason that why we are discussing incentive over here that it has even though it is promoting the beneficial activity, it also helps to resolve the moral hazards. Now, the moral hazards comes from principal agent problem. Now, what is this principal agent problem? This comes from a managerial theory and which talks about conflict of interest between manager and owner of the firm. When the owner is not the manager, there is always a conflict of interest between the manager and owner of the firm. Because manager are more interested in maximization of their own benefit rather than the maximization of the corporate profit or the firm's benefit. So, their activity goes in that direction that they maximize their own benefit, maximize their own profit rather than maximizing the firm's profit and that leads to conflict of interest between the manager and owner of the firm. Because owner's focus is always on the maximization of corporate profit rather than the individual profit or the individual benefit. Now, why this conflict comes? Because of the asymmetric information. Now, what is asymmetric information? We take the example suppose what we generally face in the day to day life. When you are going out for a vacation, basically we always assign the task of ticket booking, hotel booking and other amenities to a tour operator. Why to a tour operator or why to a travel agency? Because we feel that they have more information about the different facility, they have more information about that place, they have more information about the amenities in that place. So, they can give a better facility, they can give a better service rather than doing it in their own. So, in this typical case if you look at if you are traveling and all these ticketings and the hotel bookings and the booking for other amenities is done by a travel operator, in this case you are the principal and the travel operator is the agent. In this case the agent will try to maximize his own benefit when they are doing the action for you do you or for they are doing the activity for you. And why there is a conflict of interest? The principal do not have much of information that they can do this activity on their own. The agent has the information and since they have the information they want to maximize some profit, some benefit from their information available to them as compared to the principal. So, if you look at the major reason for the principal agent problem or the conflict of interest between the manager and the owner in a specific form case is because of asymmetric information. Because of principal agent problem or because of asymmetric information it leads to two problems. One is adverse selection and second one is the moral hazards. What is adverse selection? Adverse selection is the immoral behavior that takes advantage of asymmetric information before a transaction. The typical example is medical insurance. If you look at the person who has already affected of one kind of illness they are more serious about taking a medical insurance rather than a healthy person. In this case the person who has already faced the illness once they show immoral behavior and take advantage of the asymmetric information. The second category or the second type of problem comes in principal agent or the asymmetric information problem is moral hazards. When the behavior of one party may change the detriment of another after a transaction takes place. The typical example is that when the person knows that there is a healthy insurance associated with a job they join the job because they know because they because they know that they are going to get the medical facility after it. So the difference between the adverse selection and the moral hazards is in both this case there is immoral behavior but in case of adverse selection immoral immoral behavior is before a transaction and in case of moral hazards immoral behavior is after the transaction. So this medical insurance the example of medical insurance we can take in both these cases. One case where the affected person is more serious about the medical insurance than the healthy person and second the moral hazards the typical who has got the job or the person who has the offer of the job they join the job knowing that there is a health insurance and they will get a medical benefit once they join the job. You can take one more example is under moral hazards which is may be in a general in nature for example the person with insurance against the automobile theft may be less cautious about locking their car because the negative consequence of vehicle thefts are at least partially the responsibility of the insurance company. Their vehicle is ensured so you are less careful or you are less cautious about locking the car because you know if something goes wrong with your vehicle if something goes wrong with your car may be sometimes the insurance company pays the entire amount and sometimes its partial amount. So the whatever the risk that gets share between another party and that is the reason you are showing immoral behavior. If there is no insurance may be the person will be more careful for the security of their vehicle or security of their car. But since there is a insurance there is a third party paying for it they are less careful or they are showing the immoral behavior. This is a typical example of moral hazards that generally comes from the principal agent problems or that generally comes from the asymmetric information. Or to resolve the moral hazards instead comes into picture. Now what are the two ways for solving this moral hazards? The two general approach or two general solution. One is to invest in monitoring and surveillance and other method of collecting information about the behavior of the party subject to moral hazards. Then those economic agents which showing immoral behavior or information about the behavior of the party. And second to align the incentive of the party subject to moral hazard with those less informed party. So if there is incentive associated with that may be the immoral behavior is less. So the first one is monitoring the immoral behavior and second one is that there is an incentive or to align the incentive of the party subject to moral hazard with those there is a less informed party. So if you are showing less immoral behavior there is an incentive associated with this. So one is monitoring second one is the benefit of the incentive associated with a associated with not showing the moral behavior. For this there are type of incentive scheme one is performance pay. In case of performance pay the incentive scheme resolve the moral hazards by tying payment to some measure of performance. If you look at what how the insurance charges for your vehicle every year differs. If you are met with an accident if you are met with an theft generally the insurance premium increases. If there is no eventuality happens in the last one year generally the insurance premiums are less. So this is one way act as an incentive scheme to resolve the moral hazards by tying a payment to the some measure of performance. So this is the incentive because there is no immoral behavior in the last one year you are paying less premium less insurance premium in this typical premium. So this scheme depends on a link between the unobservable action and some observable measure of performance. The action is not observed but if you are not showing immoral behavior there is always an incentive link to that there is always a benefit link to that. The second one is performance quota there is a minimum standard of performance below which a worker is subject to penalty. The penalty could include deferral of promotion reduction in pay or even dismissal. Let us take an example of the salesman. In the previous case if you in case of performance pay if you are taking the example of a salesman how it works? You can talk about two scenario over here. You are giving 50 rupees to a salesman for the day. The salesman knows that if he is selling 1 unit, 10 unit, 15 unit, 20 unit, 100 unit is going to get 50 rupees not more than that it is a fixed pay associated with that. There is no incentive for him to show immoral behavior put more effort so that the sales will increase and even his own personal benefit will increase. So there is no performance pay that is fixed pay. The second scenario is the salesman get 2 rupees for each unit what he is selling. Now in this case how it works the more he sells more benefit he is getting. So this is the way there is a time payment to some measure of performance and this is a typical example of performance pay where the economic agent has to put more effort in order to get more benefit. So in one way this works out well for the firm this works out well for the salesman. The sell more they get more benefit they get more incentive the sell less they are getting less profit less incentive. For the firms how it works if they are paying more they are paying for each unit of the sell the salesman would always try to sell more which will also increase the sales revenue of the firm. So this second scenario is the example of the performance pay where the performance associated with each unit of the activity there is a monetary payment for each unit of the activity and this works well for the economic agent whether the economic agent adjusts salesman where the economic agent is the firm. Then we will talk about the performance quota. Suppose there is a firm who is having tell salesman what is performance quota there is a quota identified by the firm suppose every day they have to at least sell 10 unit of the goods. Now what is the incentive for the salesman by any means at least they have to reach 10 units of the they have to sell 10 units of the goods if they are not doing that there is a penalty associated with that. Now what is the penalty maybe it will come as a in case of different of promotion because they are not meeting the deadlines they are not meeting the targets. And if the if they are not reaching the quota for a longer period of time sometimes the reduction in pay or even the dismissal may comes as a penalty because they are not able to perform their job properly. Now how it will work as a incentive if the quota is 10 units if they are selling anything above that if a salesman is selling anything above that there is a incentive associated with that. This will work positively for both the firm and the salesman. How it works positively for the salesman after meeting the quota they will try to sell more because with each unit they are getting more and more benefit. So quota is the minimum standard of performance above which they are getting the incentive below which they are subject to penalty. So in this case the incentive is to sell more more than the quota get the incentive and this will also leads to the leads to the reduction of the immoral behavior by the salesman where they will feel that after reaching the quota there is nothing but if there is incentive after the reaching the quota they will work for selling more which works positive for the firm because it also increase the sales revenue of the firm. This is a cost effective way of inducing the workers to choose the economically efficient level of effort. It is cost effective because it does not reward effort below or above the economically efficient level. It focus the incentive at the economically efficient level of effort. The third one is relative performance incentive. In some situations the moral hazard can be resolved in a very natural way without imposing the risk. By gauging the performance on a relative basis the incentive scheme cancels out the effect of externalist factor to the external the effect all workers equally. So in this case if you look at there is a average performance will be decided by the firm. Now what is the average performance they will take the performance of all the salesman in typical time period they will find out the average performance. If any workers is doing more than the average performance then they are getting incentive. If they are not doing more than that they are just getting the whatever the regular payment associated with their job. In this case there is some externalist factor which may affect the worker that goes out because we are taking the average performance of all the salesman. And this works well because in this case it is not an absolute performance rather it is a relative performance of all the economic agent or in a specific case the all the salesman they are working for the firm. So in incentive there are three types of incentive one is performance pay that is per unit incentive for the pay. Second one is performance quota they have to meet the quota if they are meeting the quota above then they are getting a incentive if they are not meeting the quota if it is below the quota then they are getting a penalty. And third one is the relative performance incentive which says that like if you look at the performance of all the economic agents is taken in a average level and there is no extraneous factor is getting influencing the economic agents or influencing the salesman. Then we will come to a economic concept that is marginal analysis. This is more crucial because if you look at in managerial economics theory this marginal analysis comes for our each type of analysis or each type of application. Now what is marginal analysis? This deals with a unit increase in the cost revenue or utility suppose the variable is cost suppose the variable is revenue or suppose the variable is utility the concept of marginality deals with a unit increase in the cost revenue or utility. Now what is marginal? Marginal cost or marginal revenue or marginal utility is the change in the total cost revenue utility due to unit change in the output. So basically the marginal is the concept of marginality is the unit increase or unit change in any variable that is cost revenue or the utility. So marginal cost revenue utility is the total cost utility revenue of the last unit of output. So if you are taking a typical case of marginal cost that is marginal cost of what is the n unit that is total cost of n unit minus total cost of n minus 1 unit where the n is the number of unit of output. So marginal cost is nothing but the cost associated or the difference in the cost between n unit and the n minus 1 unit that is the marginal cost. So the marginal cost is the cost as total cost of the last unit of output that is the marginal cost of the present unit. As we know profit is the revenue minus cost. So change in the total revenue arising from a unit change in the output that is marginal revenue that is if you are discussing in term of the calculus in term of the derivative then this is the first order derivative of the total revenue function with respect to the output. So profit is revenue minus cost. Now any change in the total revenue arising from a unit change in the output is marginal revenue and marginal revenue is the derivative, the first order derivative of total revenue with respect to total output. So the slope or the calculus derivative of the total revenue curves that gives us the marginal revenue curve. So geometrically the slope of the total revenue curves gives us the marginal revenue curve. Similarly what is the change in the total cost? Whatever the change in the total cost arising from a unit change in the output that is the marginal cost. So one unit change in the output whatever the cost incurred that becomes the marginal cost and geometrically if you are discussing if you are trying to find out the marginal cost this is the slope of the total cost curve. So three ways to represent this marginal one where this is just the per unit change in the output or the last whatever the revenue cost associated with the last unit of output. Second mathematically how we can find out the cost between the difference in the total cost between the last unit and the present unit and geometrically how we can get this marginal cost and marginal revenue. So the slope of the total revenue curves gives us the marginal revenue curve and the slope of the marginal cost curve. So slope of the total cost curve that gives us the marginal cost curve. So in the next class we will discuss more about the marginal analysis and incremental analysis and this is the reference whatever is being followed for this typical session. Thank you.