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PowerPoint Slides © Michael R. Ward, UTA 2014

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1 PowerPoint Slides © Michael R. Ward, UTA 2014

2 Organizational Size A Short History Parallel History
Econ 5313 Organizational Size A Short History Middle Ages ( ) – sole craftsman had shop downstairs Early Industrial Revolution ( ) – cottage industry had handful of workers (Smith’s Pin Factory) Latter Industrial Revolution ( ) – Rise of the mills with workers Early Industrial Age ( ) – Factory system with 100-1,000 workers per plant Later Industrial Age ( s) – Multi-plant firms with up to 100,000+ workers Information Age (~1960s-) – Smaller firms and smaller worksites Parallel History Large scale agriculture – plantations with up to 1,000 slaves Military – army with up to 30,000 pseudo-slaves

3 Interpretation for Structure
Econ 5313 Interpretation for Structure Pre-Industrial Society Where there were economies of scale (e.g. plantations and military), a rigid and centralized decision making process was in place Otherwise, craftsman was worker/owner Industrialization Process New technologies with economies of scale Relevant information was increasingly collected by at lower levels Good decisions often require line workers to exercise discretion How to align goals of worker with goals of firm so that good decisions result?

4 Auction Service International
Econ 5313 Auction Service International Auction Service International (ASI) employed art experts to convince owners of valuable art to use auction services to sell their artwork The auction house profited by charging the art owners a percentage of the sell price at auction This percentage was negotiated by the young art experts The 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 owner What are two possible solutions for this problem?

5 Principal-Agent Model
Econ 5313 Principal-Agent Model When studying firm-employee relationships we use principal-agent models A principal wants an agent to act on her behalf Agents often have different goals and preferences that make acting in the principal’s interest costly The auction house is a principal; the art expert is an agent “Office Space” scene

6 Principal-Agent Model
Econ 5313 Principal-Agent Model Agents and Principals have different incentives The principal must manage the incentive conflict, which comes down to two problems: Adverse selection: the principal has to decide which agent to hire Moral hazard: once hired, the principal must find a way to motivate the agent Both 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 level The costs of addressing moral hazard and adverse selection are known as agency costs, because they are often analyzed by principal-agent models

7 Econ 5313 Reducing Agency Costs A 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 hired To mitigate moral hazard problems, firms can monitor an agent’s behavior while working This 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 5313 Incentive Pay Incentive 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 commission But incentive pay also imposes risk on agents Commissions mean a portion of an agent’s compensation is dependent on factors beyond the agent’s control, e.g., weather Agents must be compensated for taking on this additional risk So, 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 5313 Decision Making Problems In an ideal organization Decision-makers have all the information necessary to make profitable decisions And the incentive to do so When 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 system A reward system

10 Econ 5313 University Faculty Ex Faculty are evaluated annually on: 1) research 2) teaching 3) service Research – Ranking system of publishing in quality journals, grants, etc. is rather informative Teaching – Student evaluations are not very informative Service – Committee membership activity Linkage 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 5313 Centralize versus Decentralize How should decision rights be assigned? Decentralize decision making: move decision rights down in the hierarchy, closer to those with better information Centralize decision making: move decision rights up in the hierarchy, closer to those with better incentives Information must flow to decision maker Information is usually decentralized If you centralize decision-making, find a way to transfer information to those making decisions Compensate good decisions Incentive are usually better higher up the hierarchy If you decentralize decision-making authority, you should also strengthen incentive-compensation schemes

12 Decision Rights Tradeoffs
Econ 5313 Decision Rights Tradeoffs Is 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 context Faculty Example Extremely decentralized – e.g., research topic, course content But weak incentives Prediction: deadwood

13 Performance Evaluation
Econ 5313 Performance Evaluation Informal: using subjective performance evaluation Formal: using objective measures such as sales or accounting profit, stock price, relative performance metrics Rewards: Decide how compensation is tied to performance evaluation Reward good performance and/or penalize bad performance Ex Bonus, increased probability of promotion, faster promotion , first choice in scheduling

14 Multiple Objectives Evaluation of performance on multiple objectives
Econ 5313 Multiple Objectives Evaluation of performance on multiple objectives Ex 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 objectives Do 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 5313 Sales versus Marketing Sales and marketing divisions often have incentive conflict Sales wants to maximize revenue, i.e., all sales where MR > 0 Marketing wants to maximize profit, i.e., all sales where MR > MC In other words, sales prefers a higher level of sales and a lower price than does marketing Ex A large telecommunications equipment company that serves government agencies that buys telecom equipment Sales 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 5313 Sales versus Marketing Two 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 5313 Threshold Compensation How 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 5313 Group Incentives Group incentives are usually weaker than individual incentives due to free-riding Often it is impossible to discern the contributions of each making any incentive contract a group incentive contract Ex Incentives for teachers One incentive scheme was for groups of teachers teaching the same subject within a grade and school Linking pay to performance of students across classes has been shown to improve academic performance (Imberman and Lovenheim, 2012)

19 Teacher Group Incentives
Econ 5313 Teacher Group Incentives Why base incentives on teacher groups and not individual teachers? Student performance data available for each teacher But individual teacher incentives do not seem to work Possible explanations for better performance with group incentives: Avoids teachers “cherry-picking” students Sorts students into different classes – based on student ability or, say, unruliness Captures spillovers within the teacher group Demonstrates possibilities to other teacher groups

20 Econ 5313 Franchising Incentive conflict exists between franchisors (McDonalds) and its franchisees (local businessmen) McDonalds wants big franchise fees and high quality at franchisees to protect its reputation Franchisees want smaller fees and lower quality (cheaper) Stores are both company-owned and franchisees In 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 workers Franchisees 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 5313 Franchising Why 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 areas Like at freeway off-ramps or inside amusement parks

22 Hotel Employees Ex Confessions of a Hotel Maid
Econ 5313 Hotel Employees Ex 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 5313 Hotel Employees Motivate maids with informal incentive compensation It is possible to implement hiring practices characterized by low initial pay with more bonuses and more merit based pay Freedman and Kosová find that, relative to company owned hotels, franchise operations rely more on such hiring practices So, to address worker shirking you need to address store manager shirking Franchising can help solve this problem

24 From the Blog Chapter 21 High Powered Incentives and Sales Bunching
Econ 5313 From the Blog Chapter 21 High Powered Incentives and Sales Bunching DC Teacher Incentives Doing Good Wall Street reacts to Steve Balmer stepping down

25 Econ 5313 Main Points Principals and Agents typically have different goals that cause an incentive conflict This kind of incentive conflict is called an “agency problem” and leads to moral hazard and adverse selection The costs of the agency problem fall when the principal is better informed but sometimes the information is too costly Fixed pay and monitoring Incentive pay with little monitoring Hybrid

26 Econ 5313 Main Points Decision makers should have necessary information and appropriate incentives Decentralizing usually requires stronger incentives at the fringe Centralizing usually requires enhanced information flow Analyze 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?

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