2 Organizational Size A Short History Parallel History Econ 5313Organizational SizeA Short HistoryMiddle Ages ( ) – sole craftsman had shop downstairsEarly Industrial Revolution ( ) – cottage industry had handful of workers (Smith’s Pin Factory)Latter Industrial Revolution ( ) – Rise of the mills with workersEarly Industrial Age ( ) – Factory system with 100-1,000 workers per plantLater Industrial Age ( s) – Multi-plant firms with up to 100,000+ workersInformation Age (~1960s-) – Smaller firms and smaller worksitesParallel HistoryLarge scale agriculture – plantations with up to 1,000 slavesMilitary – army with up to 30,000 pseudo-slaves
3 Interpretation for Structure Econ 5313Interpretation for StructurePre-Industrial SocietyWhere there were economies of scale (e.g. plantations and military), a rigid and centralized decision making process was in placeOtherwise, craftsman was worker/ownerIndustrialization ProcessNew technologies with economies of scaleRelevant information was increasingly collected by at lower levelsGood decisions often require line workers to exercise discretionHow to align goals of worker with goals of firm so that good decisions result?
4 Auction Service International Econ 5313Auction Service InternationalAuction Service International (ASI) employed art experts to convince owners of valuable art to use auction services to sell their artworkThe auction house profited by charging the art owners a percentage of the sell price at auctionThis percentage was negotiated by the young art expertsThe negotiated “commission” rates were supposed to be between 10 and 30%, but were consistently low, near 10%The CEO of ASI began investigating this phenomenon and found that the art experts were “trading” low prices for kickbacks from the art ownerWhat are two possible solutions for this problem?
5 Principal-Agent Model Econ 5313Principal-Agent ModelWhen studying firm-employee relationships we use principal-agent modelsA principal wants an agent to act on her behalfAgents often have different goals and preferences that make acting in the principal’s interest costlyThe auction house is a principal; the art expert is an agent“Office Space” scene
6 Principal-Agent Model Econ 5313Principal-Agent ModelAgents and Principals have different incentivesThe principal must manage the incentive conflict, which comes down to two problems:Adverse selection: the principal has to decide which agent to hireMoral hazard: once hired, the principal must find a way to motivate the agentBoth problems are caused by asymmetric information:Adverse selection implies that only the agent knows his “type”Moral hazard means that only the agent knows his effort levelThe costs of addressing moral hazard and adverse selection are known as agency costs, because they are often analyzed by principal-agent models
7 Econ 5313Reducing Agency CostsA principal can reduce agency costs if she gathers information (reduces information asymmetry)about the agent’s type (adverse selection)about the agent’s actions (moral hazard)Information gathering:To mitigate adverse selection problems, firms can run background checks on agents before they are hiredTo mitigate moral hazard problems, firms can monitor an agent’s behavior while workingThis difference in timing leads to the characterization that adverse selection is a pre-contractual problem, while moral hazard is a post-contractual problem
8 Econ 5313Incentive PayIncentive pay can help align the incentives of employees (agents) with the goals of the organization (principal)For example, if harder work leads to higher sales, then create incentives by tying the employee’s reward to sales performance, e.g., with a sales commissionBut incentive pay also imposes risk on agentsCommissions mean a portion of an agent’s compensation is dependent on factors beyond the agent’s control, e.g., weatherAgents must be compensated for taking on this additional riskSo, incentive compensation represents a tradeoff:Does the benefit (harder work by agent) outweigh the cost (extra compensation for bearing risk)?
9 Decision Making Problems Econ 5313Decision Making ProblemsIn an ideal organizationDecision-makers have all the information necessary to make profitable decisionsAnd the incentive to do soWhen designing an organization, you should consider how to structure the following three items:Decision rights: who should make the decisions?Information: is the decision-maker provided with enough information to make a good decision?Incentives: does the decision-maker have the incentive to do so?Incentives are created by linking:A performance evaluation systemA reward system
10 Econ 5313University FacultyEx Faculty are evaluated annually on: 1) research 2) teaching 3) serviceResearch – Ranking system of publishing in quality journals, grants, etc. is rather informativeTeaching – Student evaluations are not very informativeService – Committee membership activityLinkage to pay?Budget Freeze?Chair allocates budget increase proportionally?Outside offer!Elaborate evaluation system is useless if not linked to a reward system(Also, reward system useless if evaluating wrong metrics)
11 Centralize versus Decentralize Econ 5313Centralize versus DecentralizeHow should decision rights be assigned?Decentralize decision making: move decision rights down in the hierarchy, closer to those with better informationCentralize decision making: move decision rights up in the hierarchy, closer to those with better incentivesInformation must flow to decision makerInformation is usually decentralizedIf you centralize decision-making, find a way to transfer information to those making decisionsCompensate good decisionsIncentive are usually better higher up the hierarchyIf you decentralize decision-making authority, you should also strengthen incentive-compensation schemes
12 Decision Rights Tradeoffs Econ 5313Decision Rights TradeoffsIs it easier to get the information to flow from its source to a different decision maker?Or is it easier to create incentives for the one with the information to make good decisions?Or is it easiest to have someone else make the decision?Depends on specific contextFaculty ExampleExtremely decentralized – e.g., research topic, course contentBut weak incentivesPrediction: deadwood
13 Performance Evaluation Econ 5313Performance EvaluationInformal: using subjective performance evaluationFormal: using objective measures such as sales or accounting profit, stock price, relative performance metricsRewards: Decide how compensation is tied to performance evaluationReward good performance and/or penalize bad performanceEx Bonus, increased probability of promotion, faster promotion , first choice in scheduling
14 Multiple Objectives Evaluation of performance on multiple objectives Econ 5313Multiple ObjectivesEvaluation of performance on multiple objectivesEx Convenience store manager gets bonuses tied to 10 meeting formal criteria (e.g., sales targets, promotional product sales, low employee overtime, low employee turnover, low stock-outs, etc.)Impossible to meet all but you earn bigger bonus for meeting more objectivesDo you strive for between 90% and 110% of all objectives or 101% of some and 0% of others?Faculty Example – If outside offers based solely on research output, do I care about teaching?
15 Sales versus Marketing Econ 5313Sales versus MarketingSales and marketing divisions often have incentive conflictSales wants to maximize revenue, i.e., all sales where MR > 0Marketing wants to maximize profit, i.e., all sales where MR > MCIn other words, sales prefers a higher level of sales and a lower price than does marketingEx A large telecommunications equipment company that serves government agencies that buys telecom equipmentSales people want to bid more aggressively to make sure that they win the contract (they care about maximizing sales)Marketing wants the sales agents to bid less aggressively, so that when they do win, the contracts are more profitable (they care about maximizing profit)
16 Sales versus Marketing Econ 5313Sales versus MarketingTwo solutions to marketing versus sales:Centralize sales decisions to marketing; and try to transfer enough information to marketing managers so they know how aggressively to bid (car salesman/manager?)Decentralize sales decisions (keep decision rights with the sales people) and change incentives but they have no decision rights over price (shoe salesman)Instead of a 10% commission on revenue, give sales people a 20% commission on profit, (revenue neutral if the contribution margin is 50%)Ex Rockford Files
17 Threshold Compensation Econ 5313Threshold CompensationHow well do threshold compensation schemes work, e.g., a bonus if you open hit a target sales number?How well do high-powered sales commissions work, e.g., 5% commission for sales of $1M; 10% commission on sales of $2M, work?Ex Pass Comps with “Incredible Marginality”
18 Econ 5313Group IncentivesGroup incentives are usually weaker than individual incentives due to free-ridingOften it is impossible to discern the contributions of each making any incentive contract a group incentive contractEx Incentives for teachersOne incentive scheme was for groups of teachers teaching the same subject within a grade and schoolLinking pay to performance of students across classes has been shown to improve academic performance (Imberman and Lovenheim, 2012)
19 Teacher Group Incentives Econ 5313Teacher Group IncentivesWhy base incentives on teacher groups and not individual teachers?Student performance data available for each teacherBut individual teacher incentives do not seem to workPossible explanations for better performance with group incentives:Avoids teachers “cherry-picking” studentsSorts students into different classes – based on student ability or, say, unrulinessCaptures spillovers within the teacher groupDemonstrates possibilities to other teacher groups
20 Econ 5313FranchisingIncentive conflict exists between franchisors (McDonalds) and its franchisees (local businessmen)McDonalds wants big franchise fees and high quality at franchisees to protect its reputationFranchisees want smaller fees and lower quality (cheaper)Stores are both company-owned and franchiseesIn a company-owned store, both adverse selection and moral hazard are concerns – managers don’t work as hard as owners and salaried manager positions might attract lazy workersFranchisees have bigger incentive to work hard (because they are the “residual claimants” of profit) but have to have their quality monitored
21 Franchising Why both company-owned and franchisees? Econ 5313FranchisingWhy both company-owned and franchisees?Where would you expect to see either?Where is demand greatly affected by manger effort?Company run stores tend to be located in tourist areasLike at freeway off-ramps or inside amusement parks
22 Hotel Employees Ex Confessions of a Hotel Maid Econ 5313Hotel EmployeesEx Confessions of a Hotel Maid“I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray-and-wipe kind of day… After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn't tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots… I apologize to you now if you ever stayed in one of my rooms. You deserved better. But if housekeepers were paid more than minimum wage — and the tips were a bit better — I might have cleaned your toilet rather than just flushed it.”How do you motivate this worker?
23 Hotel Employees Motivate maids with informal incentive compensation Econ 5313Hotel EmployeesMotivate maids with informal incentive compensationIt is possible to implement hiring practices characterized by low initial pay with more bonuses and more merit based payFreedman and Kosová find that, relative to company owned hotels, franchise operations rely more on such hiring practicesSo, to address worker shirking you need to address store manager shirkingFranchising can help solve this problem
24 From the Blog Chapter 21 High Powered Incentives and Sales Bunching Econ 5313From the BlogChapter 21High Powered Incentives and Sales BunchingDC Teacher IncentivesDoing GoodWall Street reacts to Steve Balmer stepping down
25 Econ 5313Main PointsPrincipals and Agents typically have different goals that cause an incentive conflictThis kind of incentive conflict is called an “agency problem” and leads to moral hazard and adverse selectionThe costs of the agency problem fall when the principal is better informed but sometimes the information is too costlyFixed pay and monitoringIncentive pay with little monitoringHybrid
26 Econ 5313Main PointsDecision makers should have necessary information and appropriate incentivesDecentralizing usually requires stronger incentives at the fringeCentralizing usually requires enhanced information flowAnalyze agency problems with three questions:Who is making the bad decision?Do they have enough information?Do they have strong enough incentives?Alternative solutions involve:Changing decision rights?Transferring information?Changing incentives?