Economics of Strategy Slide show prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc. Chapter 14 Agency and Performance Measurement Besanko, Dranove, Shanley and Schaefer, 3 rd Edition

The Principal/Agent Framework How does a firm make its employees work to advance the firm’s strategy? The principal/agent framework us useful in addressing this question Framework: Principal hires the agent to take actions that affect the pay off to the principal

Typical Principal/Agent Situations SubordinateManager CEOShareholder LawyerLitigant AgentPrincipal

Agency Problems Principal gets value created by agent’s action minus payment to agent Agent looks at his/her payment less the cost of his/her effort Conflict arises if there is no mechanism to align the interests of the two parties

Mechanism to Resolve Conflicts There are several means used to align the employee's interest with that of the employer – Bonuses – Raises – Profit sharing – Stock options – Future promotion – Threat of firing

Incentives and Contracts Agency problems are easy to resolve if complete contracts are possible Some actions of the agents may not be observable (hidden action) Some information may be available to the agent but not to the principal (hidden information)

Incentives and Contracts Enforceable contracts cannot be written based on unobservable actions/information – When explicit contracts are inadequate, implicit contracts can help – Implicit contracts are based on the value of long term cooperation

Explicit Incentive Contracts Contracts can be based on “performance measures” – Sales – Sales growth – Production Contracts can also be based on “input-based measures” – Number of patients seen – Number of students enrolled

Employee Reaction to Contracts Once the contract is in place, employee maximizes her/her well being Employee will put in the extra effort only if justified by the extra compensation

Let the dollar value of employees effort be: Since, he will raise the effort from 40 to 41 if there is extra compensation of $0.50 Numerical Example

Numerical Example (Continued) Each unit of effort brings in $100 in revenue If the extra unit of effort bring in extra revenue of $100 to the employer, employer's potential surplus is $99.50 Need a contract that will induce the employee to put in the extra effort

Numerical Example (Continued) Employee’s alternative is a no-extra-effort job that pays $1000 Employer wants to offer a package that makes the job barely more attractive than the alternative Employer wants to maximize profits

Numerical Example (Continued) If the commission is 10% of sales, the effort level will be such that the marginal cost of effort = $10 Effort level: e=50 Base pay + Commission should be at least, cost of effort S = Minimum base pay 550

Employment Contracts and Incentives Level of effort depends on marginal benefit and not level of pay Firm can increase the commission rate and lower the base pay to increase profits Optimum base pay can even be negative (as in the case of franchises)

Employment Contracts and Incentives Performance-based pay allows the employee to exploit his/her private information Performance-based pay may result in beneficial self selection of employees

The Downside of Pay-for-Performance Pay-for-performance can have a component of risk Pay-for-performance may not be measurable without error If employee is risk averse, pay-for- performance contracts will have to offer risk premiums

The Downside of Pay-for-Performance If employee may be engaged in multiple tasks (sales and customer service) Employee may focus on task that brings more reward to him/her Typical performance measures may not capture all aspects of performance

Risk Aversion A risk averse person prefers a sure $1000 over getting $1500 and $500 with equal probabilities Certainty equivalent is the dollar amount a risk averse person will accept in lieu of the uncertain payoff A risk averse person may consider a sure $900 of the same value as getting $1500 or $500 with equal probabilities

Risk Sharing Risk averse persons can improve their situation through risk sharing Principle behind insurance – pooling of risk If one party is risk averse and another party is risk neutral, risk should be shifted to the risk neutral party

Risk Sharing Risk averse person values the payoff at $900 ($1500 or $500 with equal probability) Risk neutral person values it at $1000 Make sense to trade the risk away to the risk neutral person

Risk Sharing – Numerical Example Assume certainty equivalent measures risk aversion Higher means lower certainty equivalent wage E(wage)= Expected wage Var(wage)= Variance Wage

Risk Sharing – Numerical Example Let sales have a random component The Noise term has zero mean and variance of

Risk Sharing – Numerical Example Let be the base pay Let be the commission rate Certainty equivalent pay If is increased beyond a certain level, the risk premium increases, reducing the profit

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 Activities detrimental to the firm may have a positive effect on the performance measures Possible solutions – Delink pay and performance – Job design to ensure rewards do not lead to neglect of certain tasks – Subjective performance evaluation

Selecting Performance Measures A good measure – Should not have a huge random component – Should encourage desirable activities – Should discourage undesirable activities Measures could be – Absolute measures – Relative measures Relative measures reduce risk due to common effects Relative measures may also encourage sabotage