Managerial Economics and Organizational Architecture, 5e Chapter 16: Individual Performance Evaluation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Performance Evaluation Evaluations provide employees feedback on achievement and ways to improve Evaluations are used to determine rewards and sanctions Performance evaluation entail evaluating employees as well as subunit of the firm 16-2

Incentive Compensation Again Principal-agent model Employee output: Q = e +   objective performance measure Compensation: W = W0 + Q  compensating differential 16-3

Implicit Assumptions Principal knows agent’s production function Output is single quantitative measure of performance Output can be observed at zero cost Employee cannot game the measure Employee produces a single output Mutually beneficial contract is feasible Employee works independently 16-4

Setting Performance Benchmarks Time and motion studies Engineers estimate the amount of time a task requires Determines most effective work method Past performance and ratchet effect Employees have incentives to only meet the goal and not exceed it 16-5

Measurement Costs Accounting system may need to be developed Information systems improved Value-maximizing firm improves measures as long as incremental benefits justify costs 16-6

Opportunism Gaming Horizon problem Employees may engage in dysfunctional activities to improve their evaluations Horizon problem Short-run objective performance measure may cause employees to focus on results that influence their evaluation only over their remaining time with the firm 16-7

Relative Performance Evaluation Evaluate worker output relative to their co-workers in the same job Within the firm jobs not always identical group has incentive to punish “rate busters” incentive to hire less competent workers Across firms data hard to obtain 16-8

Subjective Performance Evaluation Firms often use subjective evaluation along with objective measures Multiple tasks and unbalanced effort Workers have incentives to concentrate on activities that are easily measured The subjective measure will allow the supervisor to determine cooperation and other difficult to measure activities 16-9

Subjective Evaluation Methods Standard rating scales Rank employees on various performance factors Goal-based systems Set annual goals and then measure whether the employee achieved them Frequency Often more frequent reviews are too costly May be beneficial with new hires 16-10

Problems with Subjective Evaluations Supervisor shirking Forced distribution May result in good employees being evaluated poorly Influence costs Reneging 16-11

Combining Performance Measures Few job performance measures are purely objective or subjective Both types can be inaccurate increasing inaccuracy of either places greater weight on other inaccuracies increase employee risk Both can induce dysfunctional behaviors 16-12

Team Performance Team production Team evaluation Individual output: Qi = 5e +  Team output: Qt = 4e2 +  Team value added: E(Qt) > 2E(Qi) when e>2.5 Team evaluation peer evaluations to alleviate free-rider problems 16-13

Comparing Individual and Team Output Q Conrad and Dina’s team output Sum of Conrad’s and Dina’s individual outputs Expected output 25 e 2.5 Conrad’s and Dina’s individual effort levels 16-14

Government Regulation of Labor Markets Anti-discrimination regulations dictate clear performance evaluation systems May be inconsistent with value maximization 16-15