Stanford Business magazine

Faculty Research

Pros and Cons of Internal Resource Auctions

When managers within the same company compete for internal resources such as machines, consultants, and workspace, how does top management figure out who should get what? Recently, some organizations embraced creating markets within firms to let managers duke it out by buying and selling resources. Hewlett-Packard has created markets for allocating computing power and conference rooms, and Ford uses an internal market for distributing cars to dealers.

A recent study of internal online auctions finds that, in some cases, auctions can streamline the process of resource allocation. But researchers caution there are other instances when resources allocated through auctions will hurt the bottom line. The full study appears in the December 2007 issue of the Journal of Accounting Research.

“The problem of resource allocation has been solved before by a mathematical application known as the ‘optimal revelation mechanism,’ which uses extremely complicated rules,” says Richard Saouma, PhD ’06, one of the authors of the recent study and an assistant professor at the Anderson School of Management at UCLA. (Others were Stanley Baiman, PhD ’74, a professor at the Wharton School of Business, and Paul Fischer, a professor at Penn State’s Smeal College of Business.) Two divisions that want a single resource—such as specific machinery—might lay out their case to the CEO by describing in quantitative fashion how badly they need the machine to complete a job. The CEO must decide which division gets the machine, how to compensate each manager for completing their respective projects, and whether both divisions are even worth being in the competition.

The optimal revelation mechanism uses the quantitative information submitted to make every decision. It spits out figures dictating who should receive the resource, who should be asked to carry out the project, and how much each party should be compensated upon successful completion. The problem is that decisions may seem arbitrary. A manager may be a loser in any category without having a clear picture of what information the other side gave. Because of this, Saouma says, some firms hesitate to use the mechanism.

The researchers, including Saouma and Madhav Rajan, the Gregor G. Peterson Professor of Accounting at the GSB, used mathematical models to see what effect on company profits a simple resource auction would have compared to the optimal revelation mechanism. In many cases, they found, auctions were just as efficient and significantly simpler to implement. “This implies that ‘simple’ works,” Saouma says.

But not in all cases. For instance: A defense contractor has two divisions: one bidding for a project with the Air Force, and one making a pitch to the Navy. The same piece of machinery is essential to both projects, yet the machine can’t be split between both. Both contracts are worth a lot of money to the company.

When the competing projects are big money makers, or when the resource being auctioned is extremely critical to project success, the researchers found using a simple auction results in lower firm profits than what could theoretically be achieved by using the optimal revelation mechanism. In this case, Saouma observes, “a company is better off using the optimal revelation mechanism.”

“In cases like this, a resource bid through auction may not end up going to the division that would have made the most money for the firm,” Saouma says. “Or, the division that wins the resource may not end up paying the firm as much for the resource as it would have if the optimal revelation mechanism had been used.”

Thus in high-stakes cases, organizations will want to exert more control over how scarce resources are allocated. Leaving it up to the internal market could have a negative effect on the bottom line. Given that auctions do prove useful some of the time, and given their relative simplicity, straight auctions hold promise for companies looking for ways to take the hassle out of parceling out pieces of the finite pie. The oil company BP “used an auction to allocate pollution permits across business units, which worked very well,” Saouma says.

The study also suggests that corporate software designers and consulting firms may stand to profit handsomely by creating new products and services to assist companies in implementing internal auction mechanisms. Such services could include adjusting how the affected managers are compensated to guarantee that the internal market operates smoothly, or even hosting the electronic auction altogether.

—Marguerite Rigoglioso

Your Auditor’s Other Clients Can Affect Your Stock Price

The reliability of the financial reports an auditor issues depends on whether the auditor has multiple clients as well as upon the financial stability of the auditing firm, according to research by two accounting scholars. Moreover, the stock price of a given firm varies based on the quality of audits of other firms in the client portfolio of its auditor.

Anne Beyer, assistant professor of accounting at the Business School, and Sri Sridhar of Northwestern were prompted to build a model to analyze the impact of audits as the result of the fallout from the accounting scandals at Enron, Sunbeam, WorldCom, Tyco, Waste Management, and other firms. They wanted to know how the quality of a particular audit is related to the auditor’s client portfolio and how investors’ perception of audit quality affects the stock prices of client firms.

Their research model predicts that the market capitalization of the firm being reviewed depends not only on its publicly available audit report, but also on the audit reports of all the clients of the same auditor. Because investors can be uncertain about auditors’ integrity, they continually update their impressions. “It turns out that the market’s perception of the auditor’s integrity is influenced by all the audit reports he or she has issued,” Beyer says.

She and Sridhar also used the model to determine how increased governance regulations—such as the Sarbanes-Oxley Act and mandates of the Public Company Accounting Oversight Board—might affect the quality of audits. The model predicts that stricter governance measures can actually decrease the quality of reports issued.

“As governance measures become stricter, the opportunities for unscrupulous auditors to misrepresent the financial status of a client are reduced—and the penalties for getting caught are much greater,” Beyer explains. This is the intention of such regulations, but as incentives for presenting overly rosy pictures decline, so do those for being diligent about the first part of the auditing process—the gathering of information. “Thus, increasing governance might actually have a bad effect.”

For a more detailed account, see their March 2006 report in the Journal of Accounting Research.

Expensive Wine Tastes Better, According to Brain Study

In what will be music to the ears of marketers, the old adage that you get what you pay for really is true when it comes to that most ephemeral of products: bottled wine.

Researchers, including Business School marketing Professor Baba Shiv, asked research subjects to taste and evaluate two wines, one that cost $5 and another that cost $45. The wine was, in fact, the same, but the part of the brain that experiences pleasure became more active when the drinker thought he or she was drinking the more expensive vintage.

The study, published in the Jan. 14 Proceedings of the National Academy of Sciences, is one of many in the area of decision neuroscience that Shiv and colleagues are pursuing. In this case they used functional magnetic resonance imaging to measure brain activity. An article about some of Shiv’s other research projects appeared in the February issue of Stanford Business magazine. His coauthors for this study were Hilke Plassmann, a former Stanford postdoctoral researcher; Antonio Rangel, a former Stanford economist; and psychologist John O’Doherty of Caltech. Both Plassmann and Rangel are now at Caltech.

Elections Make Candidates Reluctant to Change Views

Politicians may have sound reasons for being unwilling to alter their policy positions, even when available information suggests changing would be in the best interest of the people they represent. That’s the conclusion of Kenneth Shotts, associate professor of political economy, and Brandice Canes-Wrone, PHD ’98, now an associate professor at Princeton, from their game-theory model looking at policy rigidity. The work was published in the May 2007 issue of American Political Science Review.

In an ideal world, they say, an incumbent would make decisions based on the available information, some of which may not be known to voters, and voters would reward the politician for good results.

Shotts gives as one example presidential decisions about going to war. “If voters want incumbents to make decisions about going to war based on available information, they should reward the incumbent by reelecting him after successful wars, but not unsuccessful ones. Also, they should not reelect the incumbent when he failed to go to war but should have, and they should reelect him when he avoids a war that would not have been a good idea.”

Due to the uncertainties of the real world and the complexities of most issues, voters instead tend to vote along ideological lines. “Even if the war goes badly, as long as it’s in line with the voters’ general leanings—hawk versus dove, in this case—they’ll reward the incumbent,” the researchers suggest.

The harmful effects of such behavior can be mitigated when voters—or shareholders in the case of elected corporate boards—are well informed about the preferences of elected decision makers as well as about the country’s or the firm’s interests, they say.

 

• Back to Top