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Chapter 18 Getting Employees to Work in the Best Interests of the Firm COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South- Western are trademarks used herein under license.

Chapter 18 – Take Aways Principals want agents to work in their (the principals’) best interests, but agents typically have different goals than do principals. This is called incentive conflict. Incentive conflict leads to moral hazard and adverse- selection problems when agents have better information than principals do. Three approaches to controlling incentive conflicts are fixed payment and monitoring (shirking, adverse selection, and monitoring costs), incentive pay and no monitoring (must compensate agents for bearing risk), or sharing contract and some monitoring (some shirking and some risk compensation).

Chapter 18 – Take Aways In a well-run organization, decision makers have (1) the information necessary to make good decisions and (2) the incentive to do so. If you decentralize decision-making authority, you should strengthen incentive compensation schemes. If you centralize decision-making authority, you should make sure to transfer needed information to the decision makers.

Review of Chapter 17 Moral hazard is post-contractual (hidden action) problem caused by asymmetric information  Problem is excessive risk taking after insurance  Looks similar to adverse selection Lessons of moral hazard  Anticipate moral hazard; it happens  You may be able to consummate the unconsummated wealth creating transaction by gathering info to remove the information asymmetry Solutions  Information (costly monitoring)  Incentives Shirking is moral hazard  May be too costly to solve

Introductory Anecdote Auction house employed art experts to convince art owners to use auction services Auction house earns money by charging the art owners a percentage of the final price at auction, a percentage negotiated by the art expert. Problem: Low negotiated prices (“commissions”) by art experts Experts “traded” low prices for kickbacks  Wine, furs, automobiles Discussion: Find at least two solutions

Principal-Agent Models Definition: A principal wants an agent to act on her behalf  Auction house is principal; art expert is agent. Agents have preferences different than those of principals.  Called “incentive conflict” Two problems  Adverse selection: how does principal pick right agent?  Moral hazard: how does principal motivate agent? Problem caused by information asymmetry

Incentive Conflict Examples Without proper control, incentive conflicts deter profitable transactions from occurring and result in “agency costs”  Shareholders/Managers  Employer/Employee  Customer/Seller  Marketing/Sales

Agency Costs Costs associated with moral hazard and adverse selection are often called “agency costs” Firms should attempt to reduce agency costs  Costs can be reduced if the principal incurs costs to gather information about The agent’s type (adverse selection) The agent’s actions (moral hazard) Information gathering  Adverse selection – background checks  Moral hazard – monitoring agent behavior

Incentive Pay vs. Risk Incentive pay imposes risk on agents  A portion of compensation is not guaranteed, i.e., “at risk” Agents must be compensated for taking on additional risk Becomes a cost-benefit calculation  Does the benefit (harder work by agent) outweigh the cost (extra compensation for bearing risk)?

Organizational Ideal In an ideal organization  Decision-makers have information necessary to make profitable decisions; and  Incentive to do so 1 st Principle: Information  Decentralization: move decision rights to those with information; or  Centralization: move information to those with decision rights 2 nd Principle: Incentives  Decentralization requires strong incentives

Controlling Incentive Conflict: Three Levers Decision rights: who decides what? Information: does the decision-maker have good information? Evaluation and Compensation  Performance evaluation If you can’t measure it, you can’t control  Solves moral hazard and adverse selection  How is compensation tied to performance evaluation? Reward good performance; and/or Penalize bad performance Limited by agent risk aversion and poor performance metrics Discussion: Auction house solutions?  Centralize decision making (what they did); or  Decentralize decision making + incentive compensation

Example: Marketing vs. Sales Large telecommunications equipment company sends sales agents out to various countries in South America to bid to supply telephone switching equipment to governments  Sales people all want to bid more aggressively to make sure that they win the contract  Marketing wants the sales’ agents to bid less aggressively, so that when they do win, the contracts are more profitable Solutions?  Centralize decisions and transfer information  Decentralize and change incentives

Example: Franchising Companies face fundamental choice when expanding and opening new stores  Company-owned  Franchises Incentive conflict exists between company owners/managers and those running stores  In a company-owned store, both adverse selection and moral hazard are concerns  Franchising is a form of incentive compensation scheme to help address the conflict  As always, addressing the conflict is costly The right choice: “It Depends!”  Compare the cost of franchising vs. its benefits  Consider “hybrid” solutions as well

Framework To analyze principal-agent problems, begin with the bad decision that is causing the problem, and then ask three questions. 1. Who is making the (bad) decision? 2. Did the employee have enough information to make a good decision? 3. Did he have the incentive to do so, i.e., how is the employee evaluated and compensated? Answers generally suggest alternatives for reducing agency costs  Change decision rights  Transfer information  Change incentives

Example: Declining Store Profits Large retail chain of “general stores” that target low income customers in cities with less than 50,000 people As the company has grown, the CEO, and the stock analysts who follow the company, notice that newly opened stores are not meeting sales projections Development agents find new store locations and negotiate leases with property owners – the company rewards these agents with generous bonuses if they open fifty new stores in a single year Agents are supposed to open new stores only if their sales potential is at least one million dollars per year, but this is obviously not happening – recently opened stores earn half this much Discussion: Ask questions and suggest solutions

Alternate Intro Anecdote Whaling ventures in the 1800s were managed by agents, who would purchase supplies, hire a captain and crew, and plan the voyage on behalf of the investors. Agent’s performance difficult for investors to observe or evaluate Actions of crew on multi-year voyages even more difficult to evaluate Contracts and organizational forms century evolved in response to these problems  Most whaling enterprises were closely held by a small number of local investors  Ownership rights were allocated to create powerful incentives for their managers  Agents usually held substantial ownership shares in their ventures

Alternate Intro Anecdote (cont.) Attempting to run these ventures via corporation form in the 1830s and 1840s failed  They paid their crews the same ways, used similar vessels, and employed agents with similar responsibilities  Only main difference was in ownership structures and hierarchical governance  They were unable to create the incentives requisite for success in the industry. The managers of these corporations, who did not hold significant ownership stakes, did not perform as well as their peers in unincorporated ventures.