Economics of Strategy Fifth Edition Slides by: Richard Ponarul, California State University, Chico Copyright  2010 John Wiley  Sons, Inc. Chapter 16 Performance Measurement and Incentive in Firms Besanko, Dranove, Shanley, and Schaefer

Performance Measurement Tying employees pay to performance can solve agency problems. Pay-for-performance entails two costs.  Performance measures may be affected by random factors not under employees’ control  Performance measure may not capture all aspects of desired performance.

The Downside of Performance Measurement Randomness subjects employees to risk. Risk averse employees need to be compensate for risk that comes with the job Employee may focus on tasks that brings more reward. There could be a misalignment between corporate goals and employee decisions.

Risk Aversion A risk averse person prefers a safe outcome to a risky outcome with the same expected value. A risk averse person prefers a sure $100 over getting $160 and $40 with equal probabilities (expected value = $100). Certainty equivalent is the dollar amount a risk averse person will accept in lieu of the uncertain outcome.

Risk Sharing Risk averse persons can improve their situation through risk sharing. Principle behind insurance – pooling of uncorrelated risk. Pooling and sharing can reduce the variability without decreasing the expected value.

Risk and Incentives A firm is likely to be less risk averse than its employees. We will consider a risk neutral firm and a risk averse sales person to model the risk sharing problem. Firm has many sales persons and the risk is pooled at the firm level. If the firm’s stock is publicly traded its shareholders can diversify their portfolios.

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.  Test scores based incentives for teachers will shift their efforts towards developing test taking skills instead of critical thinking skills Activities detrimental to the firm may have a positive effect on the “performance measures.”  Divisional profits used in incentive plans can lead to conflicts over overhead cost allocation.

Limitations of Performance Measures Possible solutions for the costs of pay-for- performance  Delink pay and performance  Redesign jobs to ensure rewards do not lead to neglect of certain tasks  Use subjective performance evaluation along with direct monitoring

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

Selecting Performance Measures The choice could be between narrow measures (individual output) or broad measures (firm’s profit). Broad measures reward employees for working with their colleagues. Broad measure may be subject to more randomness than narrow measures.

Do Pay-for-Performance Incentives Work? Compensation plans affect the way employees make decisions.  For simple jobs piece rate compensation improves productivity. Pay-for-performance reduces performance along unmeasured dimensions.  Employees at job training agency focus on stronger candidates at the expense of weaker ones.

Evidence of Pay-for-Performance In settings where the jobs are complex it is difficult to relate firm wide profitability to the use of pay- for-performance. It is relatively easy to find examples of destructive effects of pay-for-performance.

Incentive Mechanisms Implicit contracts Subjective evaluation Proportion tournaments Threat of termination

Implicit Incentive Contracts Explicit incentive contracts are contracts that can be enforced by a 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 To ensure that judgments by other employees are taken into account  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 For office 1 given his effort choice e 1 probability of promotion is p(e 1 ) Wage increase if promoted is (w* - w) Cost of effort = c(e 1 ) Officer 1 maximizes p(e 1 ) (w* - w) - c(e 1 )

Promotion Tournaments Contestant’s effort depends on marginal benefit of effort (w* - w). Firms can increase (w* - w) to make the contestants work harder. Can either raise w* or reduce w.

Promotion Tournaments As the number of contestants increases, p(e 1 ) decreases The size of the prize (w* - w) should increase as we have more contestants If there are multiple levels of tournaments, the wage differentials increase with the level

Promotion Tournaments Winning in one level gives the winners the chance to compete in the next level. Advantages of 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.

Promotion Tournaments: Evidence In large U. S. firms substantial pay increases are associated with promotions. Wage differentials increase with rank. Difference in pay between CEOs and corporate vice presidents is larger when the vice presidents are more numerous. Firms with more vice presidents offer larger “prizes.”

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 p(w – w**) > 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 are 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 < (total benefit)/n (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 law 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 together for long periods. Teams can be structured so that team members can monitor each other.