Incentives for Distorting Information HS Construction specializes in renovations and new home construction. For incentive purposes, the company is organized on a profit-center basis with two profit centers: the renovation. division and the new home division. The critical resource of the firm is its skilled carpenters. Because there is a shortage of carpenters, HS Construction has a policy of hiring all carpenters at the corporate level and then assigning carpenters to one of the two profit centers. The union rate for carpenters is $26.00 per hour, and, at this price, the managers of the two profit centers have a joint demand for carpenters that is far in excess of the available supply.

Given this situation, the company is faced with the problem of how to ration the available supply of carpenters. The operation of each of the profit centers is subject to some uncertainty, so ex ante managerial claims regarding carpenter productivity are difficult to evaluate ex post. Consequently, the controller is reluctant to base allocations on a priori assertions by the divisional managers

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In the renovation division, the return (7) received per carpenter hour (91) is = 600 -0.1891 In the new home construction division, the return is = 300 - 0.07q2 Suppose the controller successively announces prices the divisions will pay per carpenter hour and the division managers respond with demand at that price. The controller seeks to equate demand and the supply of carpenter hours which is 2,000. Divisions will be as- sessed a charge against profits equal to the amount bid for the labor used. All managers are risk-neutral. Required (1) Suppose both divisions respond honestly to the controller's price bids: (a) How many carpenter hours will be allocated to each division? (b) What price will clear this market? (c) What will be the profit reported by each division? (2) Suppose the manager of the renovation division intends to respond honestly to the con- troller's bids. The manager of the new construction division knows this and also knows the renovation division's return function. Show that there is an incentive for the man- ager of the new construction division to be dishonest. (Hint: How would a manager be- have to produce a transfer price of $0?) (3) Can you suggest a method for solving the problem raised in Requirement 2? (4) Under what circumstances will the solution proposed in Requirement 3 not have the de- sired motivational consequences?