Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 15: Incentive Compensation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Managerial Economics and Organizational Architecture, 5e Incentives Owners and employees have different aims Owners wish to maximize profits and want employees to work diligently Employees wish to maximize utility and take breaks from working 15-2

Managerial Economics and Organizational Architecture, 5e The Incentive Problem Ian McLeod at AssemCo Ian’s utility function: U=I-e 2 Firm’s benefits from Ian’s effort is $100e profit from specified level of effort, Maximum profits occur where e=50 with the help of a bit of calculus illustrated on the next slide 15-3

Managerial Economics and Organizational Architecture, 5e Optimal Effort Choice at AssemCo 1,000 3,500 5,000 Costs (in dollars) Level of effort e* = 50 Costs of effort: $1,000 + e 2 Benefits of effort: $100e Firm profit = $1,500 e 15-4

Managerial Economics and Organizational Architecture, 5e Results The firm will pay Ian $3,500 for 50 hours of effort Problems –The firm cannot observe Ian’s effort costlessly –The firm could observe output, but it may difficult to measure and may be affected by factors beyond the employee’s control 15-5

Managerial Economics and Organizational Architecture, 5e Incentive Problems If the interests of the firm and employee are aligned, the incentive problem does not exist Contracts can solve this problem if the worker’s actions are observable There is a tradeoff between the benefits of the action for the firm and the personal costs born by the employee 15-6

Managerial Economics and Organizational Architecture, 5e Incentives from Ownership One way to avoid these problem is to sell employees the rights to their production This is seen in franchising and managerial buyouts Limiting factors wealth constraints risk aversion team production 15-7

Managerial Economics and Organizational Architecture, 5e Optimal Risk Sharing Most individuals are risk averse for given income level, prefer less dispersion in outcomes Shareholders have diverse portfolios less concerned about performance of any one company Employees receive substantial income from single company 15-8

Managerial Economics and Organizational Architecture, 5e Effective Incentive Contracts Compensation contracts have two functions motivate employees share risk more efficiently Employees prefer fixed income to random income flows Fixed incomes do not provide strong incentives Contract must balance these considerations 15-9

Managerial Economics and Organizational Architecture, 5e Basic Principal-Agent Model Employer is the principal Employee is the agent Employer is risk neutral Employee is risk averse Model illustrates tradeoffs between incentives and risk sharing 15-10

Managerial Economics and Organizational Architecture, 5e Basic Principal-Agent Model Erica Olsson of DNAcorp Erica’s output: Q=  e+ ,  ~(0,  2 ) –output depends on effort e and a random element  Profit: Π=(  e+  )-W –profit is output minus Erica’s cost to the firm Compensation: W=W 0 +  Q, 0    1 –compensation has a fixed component and an element linked to output 15-11

Managerial Economics and Organizational Architecture, 5e Employee’s Effort Problem Erica again Suppose Then W= (100e+μ) Random shocks μ affect total compensation but not the benefit of extra effort 15-12

Managerial Economics and Organizational Architecture, 5e The Employee’s Effort Choice 1,200 e* = 10 Level of effort e Compensation: $1,000 + $20e Costs: e 2 Costs (in dollars) 15-13

Managerial Economics and Organizational Architecture, 5e Changes in Compensation If the fixed wage is increased, Erica’s effort does not change If the incentive coefficient increases, her effort will increase 15-14

Managerial Economics and Organizational Architecture, 5e Effort Choice Changes with Changes in Fixed and Incentive Compensation 1,000 2,000 Costs (in dollars) Level of effort $ e β =.2 (Intercept change) β =.3 (Slope change) β =.2 (Original contract) 15-15

Managerial Economics and Organizational Architecture, 5e Factors That Favor High Incentive Pay 1.The value of output is sensitive to the employee’s effort. 2.The employee is not very risk-averse. 3.The level of risk that is beyond the employee’s control is low. 4.The employee’s response to increased incentives is high (the employee exerts substantially more effort). 5.The employee’s output can be measured at low cost

Managerial Economics and Organizational Architecture, 5e Informativeness Principle Use all appropriate information when evaluating performance Consider uncontrollable factors such as market conditions Select benchmarks to support relative performance measurement By measuring employee effort with more precision, effort choice will be more efficient 15-17

Managerial Economics and Organizational Architecture, 5e Group Incentive Pay Individual performance is difficult to measure Group pay encourages teamwork and cooperation Employees have incentives to monitor each other 15-18

Managerial Economics and Organizational Architecture, 5e Forms of Incentive Pay Piece rates and commissions Bonuses for good performance Prizes for winning contests Salary revisions based on performance Promotions Preferred office assignment Stock and profit sharing plans Deferred compensation Firings for poor performance 15-19

Managerial Economics and Organizational Architecture, 5e Does Incentive Pay Work? Critics argue that money does not motivate Also they argue it is difficult to design an effective compensation plan Evidence supports that agents do respond to incentives 15-20