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Incentives in Firm's Unobservable, Endogenous Decisions: Diversity and Service Effort


Firms make optimal decisions on the level of various marketing-mix variables to maximize profits. Some of these marketing-mix variables are unobserved by researchers, yet they are important to understand when they are endogenous in that a firm has incentives to increase or decrease them depending on how they change its profit. This thesis is focused on understanding a firm's incentive in two unobservable, endogenous decisions: workforce diversity and service effort. This thesis further builds theoretical frameworks around these two concepts, validates/estimates the model using public and proprietary data, and draws implications in market competition and policy experiment.

The literature in business, psychology, and sociology shows that there is a trade-off in hiring diverse workforce: diversity brings creative ideas that help solving problems, but it also creates friction among members. Under competition, the decision on the level of diversity of workforce is an important strategic decision that gives firms a competitive edge. We build a theoretical model with symmetric firms and find that the better a firm can deal with a diverse workforce or the more competition there is in the market, the more diverse workforce the firm will hire. We also find that a firm's profit decreases with the intensity of market competition as expected, but increases with the firm's inability to deal with diverse workforce as the inability deters competition between firms. Finally, we extend the model to firms with asymmetric private marginal costs and empirically validate the positive relationship between the diversity of workforce and the intensity of competition (industry concentration ratio, in particular) using two datasets from 1997: National Organizations Survey and Economics Census.

Service effort, often referred to as customer service, is also another important unobservable, endogenous decision that firms must make. Empirically quantifying or measuring the service effort is difficult because it is often unobservable. This paper proposes an empirical framework of the role of service effort in demand, along with other traditional marketing mix instruments. This model allows us to measure the unobserved effort level without data on effort, which is hardly available in most empirical settings. The paper also presents an application to a unique data set obtained from a franchise operating in the car radiator market. This framework can be useful in examining various aspects of service-intensive industries. In particular, this study investigates a much-debated public policy question regarding resale price ceiling in franchising. A policy evaluation shows that resale price ceiling lowers franchisees' profits and weakens their incentive to exert effort, which reduces consumer welfare. However, I find that, overall, resale price ceiling enhance consumer welfare in the car radiator market due to the lower price generated by the price ceiling.

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