Game Theory Topic 7 Information “I like work. It fascinates me. I can sit and look at it for hours.” - Jerome Klapka Jerome

The Simpsons on Incentive Pay “If you don't like your job, you don't strike. You just go in every day and do it really half-assed. That's the American way.” Mike Shor 2

The Simpsons on Incentive Pay “Behold, the greatest breakthrough in labor relations since the cat o' nine tails!” Mike Shor 3

Incentive Schemes Salary and bonus contracts can compensate for information asymmetry Often, this is unreasonable  Employees unwilling to assume risks  Contracts must be perfectly balanced May be better to settle for low effort  Employee Perceptions  Leakages  Group Rewards Mike Shor 4

A Horrible Disease A new test has been invented for a horrible, painful, terminal disease The disease is rare  One in a million people are infected The test is accurate  95% correct, 5% false positive/negative You test positive! How worried are you? Mike Shor 5

Bayes Rule What is the chance that you have the disease if you tested positive? Mike Shor 6

Leakages IBM Variable Pay  Bonus of 10% of annual earnings if “annual objectives are met in key areas” Internal Memo: “We observe, across divisions, performance in line with expectations through about March. Performance declines consistently in later months.” Mike Shor 7

Leakages If bonus is tied to  Increases over last year  Reduce this year’s growth  Output / Quantity  Reduce quality  Average customer satisfaction  Reduce number of service calls Mike Shor 8

Strategic Considerations If bonus is tied to …  Market share  Firm profits  Industry profits Mike Shor 9

Example Pharmaceutical Development

Goal: Align Research Labs’ Incentives “Strong resource devotion to select projects marginally increases the chance of success, but when considering the potential profitability of the post-patent market, it is clear that proper incentive alignment is essential.” Mike Shor 11

Market Conditions Patent races over high-profit pharmaceuticals worth up to $2 billion Resource devotion ranges from twenty to sixty hours per employee, with staff of fifty per project (low level to high level) Project time frame: 6 months Mike Shor 12

Market Conditions Independent labs contracted Average cost of labor: $16/hour Chance of success:  Minimally:1%  Maximally:2.5% Mike Shor 13

Cost Calculations Extra cost to lab of high effort: 40 hours / week / employee x25 weeks time frame x $16 / hour _ = $16,000 / employee Mike Shor 14

To entice high effort Costs:  $16,000 per employee in costs Benefits:  1½% extra chance of success (2½% - 1%) Incentive compatibility:.015 x bonus > $16,000 bonus > $1.1M Mike Shor 15

To entice high effort Bonus per employee must be greater than $1.1 million Fifty employees, so total bonus must be greater than $55 million Final conclusion $75 million bonus “to be safe” Mike Shor 16

Extra Profit if it Works Value of extra chance of success:  x $2B = $30M Cost of bonus:  x $75M = $2M Benefit of plan:  $30M – $2M = $28M Mike Shor 17

Problem Ignoring individual incentives  Analysis assuming that entire group works hard or does not Quick & Dirty Check:  If fifty people working hard increases chance of success by 1.5%, each person, on average, increases chance by only 1.5%/50 = 0.03%  Each person earns a bonus of $75M/50 = $1.5M Mike Shor 18

Conclusion A person’s value of extra time: $1.5M x 0.03% = $450 A person’s cost of extra time: $16,000 NOT EVEN CLOSE! Mike Shor 19

Summary Enticing high effort is hard work  Leakages  Global vs. individual incentives  Rewarding the right people But often worth it if you can do it right Mike Shor 20