AGENCY AND PERFORMANCE MEASUREMENT

The Principal/Agent Framework Agency Problem/Agency Conflict : # Principal's objection is to maximize value its receive # Agent is concerned with the value he receives from participating in the relationship

Using Contract.. Hidden action → aspects of the agent's action that are inmortant to the principal cannot be observed Hidden information → aspects of the productive environment that are important to the principle cannot be observed hidden action + hidden information = important aspect of agent's action or the agent's information cannot be used as basis for an incentive contract

Using contract... Explicit incentive contract : an incentive contract that can be enforced by an outside third party such as a judge or an abritator Implicit incentive contract : rely on the value of future cooperation to provide an enforcement mechanism

How to Respond the Performance Measures in Incentive Contract The relationship between pay and performance that provide incentives for effort, not the level of pay The firm can do even better if it sets a higher commision rate. Performance-based pay can help resolve hidden information problem as a well. Performance-based pay is also likely to affect the selection of employees who are attracted to the firm

COST OF TYING PAY TO PERFORMANCE Risk Aversion → prefer a safe outcome with the risky outcome with the same expected value Risk neutral → indifferent between a safe outcome and a risky outcome with the same expected value Risk seeking → prefer a risky outcome with the safe outcome with the same expected value

Preference (example)

Risk Premium Risk Premium : amount of which the decision maker discounts the risky because of the risk. Risk Premium have three key properties : # Different decision makers will apply different certainty equivalent to the same risk # For a given decision maker, the certainty equivalent is lower (and the risk premium higher) when the spread or variability in payments is greater # For a given decision maker, we can use the notion of certainty equivalent to compare different risk

Risk And Incentives Agent's action do not translate perfectly into measure performance Measure performance depend on : a. Agent's action b. Random Factor (beyond the agent's control)

Tradeoff Between Risk and Incentives Firm ties pay more closely to performance → provide stronger incentives → increase variability of employee's compensation → the job become less attractive → Firm has to pay higher overall wages in order to attract the employee → this leads to higher cost of the firm

The Tradeoff Between Risk and Incentives

Stronger Incentives when : The employee is less to risk averse The variance of measure performance is lower The employee's marginal cost of effort is lower The marginal return to effort is higher

Alternatives of incentive Promoted to a higher paying job Profit sharing Grant of stock option

Factors that make a good measure Performance measure that is less affected by random factors will allow the firm to tie pay closely to performance without introducing much variability into employee's pay Measure that reflect all the activities the firm want to undertaken will allow the firm to use strong incentives without pulling the employee's attention away from important task A performance measure that cannot be improved by action to the firm does not want to undertaken will allow the firm to offer strong incentives without also motivating counterproduct ive action

Way to measure RELATIVE measure ABSOLUTE measure

Do pay for performance incentives work ? Martin Gaynor, dkk : Quality is difficult to measure and it is hard to rule out the possibility that the cost reductions and improvements in measured quality come at the expense of quality on unmeasured dimensions

Do pay for performance incentives work ? Robert Drago and Gerald Garvey Employees help each other less and exert more individual effort when individual- based promotion incentives are strong

The difficulties to answer that question are... Comparing the profitability of firm offering pay for performance incentives question of whether incentives increase profit It is relatively easy to find examples in which pay for performance compesation plans have had destructive effects

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