Economics of Strategy Slide show prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc. Chapter 15 Incentives in Firms Besanko, Dranove, Shanley and Schaefer, 3 rd Edition

Incentive Mechanisms Implicit contracts Subjective evaluation Proportion tournaments Threat of termination

Implicit Incentive Contracts Explicit incentive contracts are contracts that can be enforced by an outside 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 even 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 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 Wage increase Cost of effort Each contestant will maximize

Promotion Tournament Contestant’s effort depends on marginal benefit of effort Firms can increase to make the contestants work harder Can either raise or reduce

Promotion and Tournaments As the number of contestants increases, decreases The size of the prize should increase as we have more contestants If there are multiple levels of tournaments, the wage differentials increase with the level Winning in one level gives the winners the chance to compete in the next level

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

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 >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 If the legal environment makes firing harder (low) efficiency wage has to increase “At-will employment” lowers the efficiency wage needed to provide the incentive not to shirk

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 and 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> (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 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 for long periods Teams can be structured so that team members can monitor each other

Problems with Stable Teams Teams that work over long periods can bring in peer pressure and social norms to make the members behave However, stable teams do not permit the observation of individual member’s abilities Firms may rotate members among teams even if there is a short run, incentive-related cost

Career Concerns and Long Term Employment In certain jobs, an important source of incentives is employees’ career concerns Employees undertake current actions that enhance their future value in the labor market Investment bankers, money managers, and professional athletes are some examples

Career Concerns and Long Term Employment Young mutual fund managers have strong incentives to avoid poor relative performance Managers with long track record can survive a bad year Evidence indicates that young managers are more likely to “follow the herd”

Career Concerns and Long Term Employment Career concerns may make employees take actions that do not help the firm (Example: Mutual fund managers) Sometimes, career concerns may provide better incentives than pay for performance rewards (Professional athletes)

Career Concerns and Long Term Employment Career concerns are weak towards the end of one’s career CEO pay is more closely tied to firm performance as the CEO approaches retirement age Contracts for older athletes include clauses for reduction in pay if they do not succeed by certain objective criteria

Career Concern and Human Capital Employees who are likely to change jobs will be interested in acquiring general purpose human capital They will be less willing to invest in firm specific skills A firm that relies on career concerns for incentives will find it hard to make the employees invest in firm specific skills

Career Concern and Human Capital Firms may have to reward employees for acquiring firm specific human capital – Offer long-term employment – Promise steeper increase in pay over time – “Back loaded” compensation Back loaded compensation can work as an efficiency wage

Incentives and Decision Making Recipients of information should have decision making rights if – Information is difficult to communicate – The value of information depreciates quickly Delegation of decision making authority should hinge on whether the decision maker can be rewarded/penalized for good/bad decisions

Incentives and Decision Making Recent innovations such as Total Quality Management and just-in-time production require delegation of decision making to line workers Adoption of such innovations should be done along with the appropriate incentive policies