D. Internal Organization of the firm 1. Agency and performance measurement 1.1. The Principal/Agent framework 1.2. Costs of tying pay to performance 1.3. Selecting performance measures 2. Incentives in firms 2.1. Implicit incentive contracts 2.2. Incentives and teams 2.3. Career concerns and long term employment 2.4. Incentives and decision making in organizations

1. Agency and Performance Measurement 1.1. The Principal/Agent framework 1.2. Costs of tying pay to performance 1.3. Selecting performance measures

The Principal/Agent Framework How does a firm make its employees work to advance the firm’s strategy? The principal/agent framework is useful in addressing this question Framework: Principal hires the agent to take actions that affect the payoff to the principal

Typical Principal/Agent Situations Subordinate Manager CEO Shareholder Lawyer Litigant Agent Principal

Agency Problems Principal gets value created by agent’s action minus payment to agent Agent looks at his/her payment less the cost of his/her effort Conflict arises if there is no mechanism to align the interests of the two parties

Mechanism to Resolve Conflicts There are several means used to align the employee's interest with that of the employer Bonuses Raises Profit sharing Stock options Future promotion Threat of firing

Incentives and Contracts Agency problems are easy to resolve if complete contracts are possible Some actions of the agents may not be observable (hidden action) Some information may be available to the agent but not to the principal (hidden information)

Incentives and Contracts Enforceable contracts cannot be written based on unobservable actions/information When explicit contracts are inadequate, implicit contracts can help Implicit contracts are based on the value of long term cooperation

Explicit Incentive Contracts Contracts can be based on “performance measures” Sales Sales growth Production Contracts can also be based on “input-based measures” Number of patients seen Number of students enrolled

Employee Reaction to Contracts Once the contract is in place, employee maximizes her/her well being Employee will put in the extra effort only if justified by the extra compensation

Numerical Example Let the dollar value of employees effort be: Since , he will raise the effort from 40 to 41 if there is extra compensation of $0.50

Numerical Example (Continued) Each unit of effort brings in $100 in revenue If the extra unit of effort bring in extra revenue of $100 to the employer, employer's potential surplus is $99.50 Need a contract that will induce the employee to put in the extra effort

Numerical Example (Continued) Employee’s alternative is a no-extra-effort job that pays $1000 Employer wants to offer a package that makes the job barely more attractive than the alternative Employer wants to maximize profits

Numerical Example (Continued) If the commission is 10% of sales, the effort level will be such that the marginal cost of effort = $10 Effort level: e=50 (Base pay + Commission) should be at least (1000 + cost of effort) S + 500 = 1000 + 50 Minimum base pay 550

Employment Contracts and Incentives Level of effort depends on marginal benefit and not level of pay Firm can increase the commission rate and lower the base pay to increase profits Optimum base pay can even be negative (as in the case of franchises)

Employment Contracts and Incentives Performance-based pay allows the employee to exploit his/her private information Performance-based pay may result in beneficial self selection of employees

The Downside of Pay-for-Performance Pay-for-performance can have a component of risk Performance may not be measurable without error If employee is risk averse, pay-for-performance contracts will have to offer risk premiums

The Downside of Pay-for-Performance If employee is engaged in multiple tasks he/she may focus on task that brings more reward Typical performance measures may not capture all aspects of performance

Risk Aversion A risk averse person prefers a sure $1000 over getting $1500 and $500 with equal probabilities Certainty equivalent is the dollar amount a risk averse person will accept in lieu of the uncertain payoff A risk averse person may consider a sure $900 of the same value as getting $1500 or $500 with equal probabilities

Risk Sharing Risk averse persons can improve their situation through risk sharing Principle behind insurance – pooling of risk If one party is risk averse and another party is risk neutral, risk should be shifted to the risk neutral party

Risk Sharing Risk averse person values the payoff at $900 ($1500 or $500 with equal probability) Risk neutral person values it at $1000 Make sense to trade the risk away to the risk neutral person

Risk Sharing – Numerical Example Assume certainty equivalent measures risk aversion Higher means lower certainty equivalent wage E(wage)= Expected value of wage payment Var(wage)= Variance of wage payment

Risk Sharing – Numerical Example Let sales have a random component The Noise term has zero mean and variance of

Risk Sharing – Numerical Example Let be the base pay Let be the commission rate Certainty equivalent pay If is increased beyond a certain level, the risk premium increases, reducing the profit

Risk Sharing Incentive component of pay can be made stronger if Employee is less risk averse Variance of performance measurement is smaller Employee is less effort averse Marginal return to effort is higher

Limitations of Performance Measures Activities important to the firm may not be reflected in the performance measures Activities detrimental to the firm may have a positive effect on the performance measures Possible solutions Delink pay and performance Job design to ensure rewards do not lead to neglect of certain tasks Subjective performance evaluation

Selecting Performance Measures A good measure Should not have a huge random component Should encourage desirable activities Should discourage undesirable activities Measures could be Absolute measures Relative measures Relative measures reduce risk due to common effects Relative measures may also encourage sabotage

2. Incentives in Firms 2.1. Implicit incentive contracts 2.2. Incentives and teams 2.3. Career concerns and long term employment 2.4. Incentives and decision making in organizations

Incentive Mechanisms Implicit contracts Subjective evaluation Proportion tournaments Threat of termination

Implicit Incentive Contracts Explicit incentive contracts are contracts that can be enforced by an outside third party For many jobs, performance measures are not perfect Implicit contracts can work in the form of supervisor’s assessment

Implicit Incentive Contracts To make implicit contracts work, the firm should ensure that the employees perceive that the firm is acting in accordance with the contract ensure that the performance standards are being applied consistently across the organization communicate clearly with the employees in the event unforeseen conditions preclude the payment of the expected rewards

Subjective Performance Evaluation Assessment takes into account factors that make it easy or difficult to attain the goals Supervisors’ reluctance to punish certain employees could lead to “ratings compression” Subjective assessments are subject to “influence” activity

Subjective Performance Evaluation Some firms use “360-degree peer review” Some use a fixed pool of points to allocate to employees Grading on a curve can address “ratings compression” Firms may limit influence activity by limiting access to decision makers

Promotion Tournaments Since higher levels have fewer position than lower levels, not every worker can be promoted to the next level The contest among workers to be promoted to the next level is like an athletic tournament Promotion tournaments can provide incentives against shirking

Promotion Tournaments Promotions typically involve marked pay increases Employees have strong incentives to take actions that will enhance their chances of being promoted Promotion criteria are not typically part of an explicit contract

Promotion Tournaments Probability of promotion depends on effort Wage increase Cost of effort Each contestant will maximize

Promotion Tournament Contestant’s effort depends on marginal benefit of effort Firms can increase to make the contestants work harder Can either raise or reduce

Promotion and Tournaments As the number of contestants increases, decreases The size of the prize should increase as we have more contestants If there are multiple levels of tournaments, the wage differentials increase with the level Winning in one level gives the winners the chance to compete in the next level

Promotion Tournaments “Winner-take-all” reward counteracts ratings compression Tournaments work as relative performance evaluation

Disadvantage of Tournaments Best performance in one level needs not indicate skills needed for the next level Tournaments can encourage sabotage

Threat of Firing and Efficiency Wages What constitutes “satisfactory” performance is commonly understood within the firm If performance is not satisfactory, worker is fired Firing is a punishment if wages are higher than what is available in the market

Efficiency Wages If employee keeps the job wage=w If employee is fired wage=w** Assume cost of effort=$50 Probability of detection, employee shirks=p Employee will not shirk if >50

Efficiency Wage To make employees not shirk, the firm can Increase p Increase w Pool of unemployed workers provides incentives for the employed

Efficiency Wages Efficiency wages are useful when monitoring is difficult Non-wage benefits will make the jobs more valuable and have an incentive effect

Efficiency Wages “At-will employment” lowers the efficiency wage needed to provide the incentive to not shirk If the legal environment makes firing harder efficiency wage has to increase If firing is harder firms may choose alternate means of providing incentives

Incentive in Teams To achieve the full benefits of team production, rewards need to be based on team output With team based performance measures, benefits from individuals actions and shared with the team Some beneficial actions may not be undertaken

Incentive in Teams If total benefit form action > total cost of action, it is a value creating action Action will be undertaken only if total cost> (n= number of members in the team) Every team member lacks the incentive to take valuable actions (free rider problem)

Incentives in Teams Free rider problem is exacerbated if a team member has another task on which he works alone Weaker incentives for team-based tasks will result in shift of effort to the individual-based task

Evidence on Incentive in Teams In medical practices, increase in the size of partnerships lead to reductions in individual productivity Larger firms are less able to control costs compared with smaller firms

Incentives in Teams – Solutions Team size can be kept small Team members can be made to cooperate by allowing them to work for long periods Teams can be structured so that team members can monitor each other

Problems with Stable Teams Teams that work over long periods can bring in peer pressure and social norms to make the members behave However, stable teams do not permit the observation of individual member’s abilities Firms may rotate members among teams even if there is a short run incentive-related cost

Career Concerns and Long Term Employment In certain jobs, an important source of incentives is employees’ career concerns Employees undertake current actions that enhance their future value in the labor market Investment bankers , money managers, and professional athletes are some examples

Career Concerns and Long Term Employment Young mutual fund managers have strong incentives to avoid poor relative performance Managers with long track record can survive a bad year Evidence indicates that young managers are more likely to “follow the herd”

Career Concerns and Long Term Employment Career concerns may make employees take actions that do not help the firm (Example: Mutual fund managers) Sometimes, career concerns may provide better incentives than pay for performance rewards (Professional athletes)

Career Concerns and Long Term Employment Career concerns are weak towards the end of one’s career CEO pay is more closely tied to firm performance as the CEO approaches retirement age Contracts for older athletes include clauses for reduction in pay if they do not succeed by certain objective criteria

Career Concern and Human Capital Employees who are likely to change jobs will be interested in acquiring general purpose human capital They will be less willing to invest in firm specific skills A firm that relies on career concerns for incentives will find it hard to make the employees invest in firm specific skills

Career Concern and Human Capital Firms may have to reward employees for acquiring firm specific human capital Offer long-term employment Promise steeper increase in pay over time “Back loaded” compensation Back loaded compensation can work as an efficiency wage

Incentives and Decision Making Recipients of information should have decision making rights if Information is difficult to communicate The value of information depreciates quickly Delegation of decision making authority should hinge on whether the decision maker can be rewarded/penalized for good/bad decisions

Incentives and Decision Making Recent innovations such as Total Quality Management and just-in-time production require delegation of decision making to line workers Adoption of such innovations should be done along with the appropriate incentive policies