1 Incentives and Agency Besanko, Dranove, Shanley, and Schaefer Chapters 14 and 15

2 Agenda Discussion of Agency Theory The Agency Relationship The Agency Contract Modeling Performance Measures Types of Contracts Risk and Contracting Firm Incentives

3 Agency Theory Agency theory is the study of incentives to motivate workers. Agency theory examines the relationship between an agent and a principal. An principal is a person/entity that delegates responsibility to another, known as the agent. The agent acts on behalf of the principal.

4 Things to Consider in the Agency Relationship What is an Agency Relationship? Problems in Agency Relationships Performance-Based Contracts and Risk Aversion The “Second-Best” Contract Limited Liability Sorting

5 What is the Agency Relationship? Anytime that an agent acts on behalf of a principal, there is an agency relationship. In an agency relationship there usually needs to be some sort of implicit or explicit contract.

6 Problems in Agency Relationships The principal and the agent tend to have different objectives (agency problems/agency conflicts). The principal’s objective is to maximize the value of the agents productivity minus the cost he must pay the agent. The agent maximizes the amount he gets paid for his work minus any incurred costs.

7 Contracting as a Method for Providing Incentives The differing objectives of the principal and the agent implies that there is a need for an alignment of their objectives. This alignment can occur through some form of contracting. Contracting is made difficult due to hidden actions and hidden information. Contracting should focus on performance measures which are visible.

8 The Agency Contract The agency contract spells out the terms of the agency relationship. The contract outlines the compensation to be made by the principal to the agent, given that a set of conditions are met.

9 Modeling Performance Measures in Incentive Contracts Suppose a firm hires an employee who exerts an effort level of e. The firm pays this employee $1000 in base salary which is the standard market rate. For each unit of effort put in by the employee, the firm’s sales increase by $10. Assume that the cost of effort is zero if the employee works 40 hours or less. Also assume that the employee is willing to work above 40 hours if he is compensated 0.5*(e-40) 2.

10 Modeling Performance Measures in Incentive Contracts Cont. What level of effort will the employee provide if he only received the base salary? What would happen if the firm paid the employee a 10% commission? What would happen if the firm paid the employee a 20% commission? What is the lowest level the firm could drop the base salary and still get the employee to work for it at the 10% and 20% rate?

11 Two Minimum Conditions of an Agency Contract The agent must be willing to accept the contract. This implies that the compensation to the agent must be equal to or greater than her opportunity cost, usually known as the threshold wage, of doing something else. The agent must be willing to comply with the contract; hopefully within an efficient manner. This implies that the contract should satisfy an incentive compatibility constraint.

12 Incentive Compatibility Constraint (ICC) The ICC spells out the incentives that will cause the agent to take efficient actions. When the agent does not take the efficient action, he is said to be shirking.

13 The First-Best Efficient Contract The first-best contract causes the agent to take efficient actions by satisfying the incentive compatibility constraint and gives the agent his threshold wage. While many of these contracts may exist, the principal prefers the contract that pays the smallest compensation necessary.

14 Three factors that Contribute to Efficiency There is no hidden information held by the agent. Principals have full information about actions. If the agent performs the contract, the agent is at little or no risk of not getting compensated.

15 Other Problems in Agency Relationships Two major issues are at the heart of the problems in agency relationships: Moral Hazard—This occurs when there are opportunities to shirk because of incomplete contracting. Imperfect Observability—This occurs when the principal cannot observe perfectly the agents actions.

16 Moral Hazard Moral hazard tends to result from either hidden actions or hidden information. Hidden actions occur when the principal cannot perfectly observe the agents actions. Hidden information occurs when the agent has information that the principal does not.

17 Observability Observability is one key way to prevent shirking. In some situations, observability is easy to achieve, especially when there are outwardly signs. In other cases observability may be difficult to directly achieve. In this case, the principal may use an observable proxy action that is highly correlated with the unobservable action.

18 Piece Rate Contracts A piece rate contract pays a fee for each unit of output produced by the agent. These contracts are easy to implement when the principal can easily observe the agent. With piece rate contracts, the principal needs to take into consideration the quality of the output.

19 Piece Rate Contracts Cont. Problems with piece rate These contracts do not generally give the efficient effort. These contracts may induce too much production.

20 Cost-Based Contracts A cost-based contract is where the principal compensates the agent for all reasonably incurred costs plus a specified level of profit. These contracts do not provide a mechanism to stop shirking.

21 Performance-Based Contracts A performance-based contract is a contract that makes compensation contingent on the agent meeting some pre-established performance objectives. Performance-based contracts must take into consideration the level of risk an agent is willing to take.

22 Three Factors that Make for a Good Measure of an Employee’s Performance One that is less affected by random factors One that reflects all the activities the firm wants to encourage One that does not encourage counterproductive activities

23 Willingness to Bear Risk There are three general classifications of a persons risk preferences: A risk averse agent is one that would prefer a guaranteed payoff over a payoff under uncertain conditions that have the same expected payoff. A risk neutral agent is indifferent as to whether to take a guaranteed payoff or a gamble that has the same expected payoff. A risk loving agent would prefer to take a gamble over a guaranteed sum of money as long as the expected return from the gamble is the same as the guaranteed sum.

24 Risk Premium A risk premium is a compensation required to induce the agent to take on some risk. When agents are risk averse, a risk premium is necessary to induce them to take on some risk.

25 The “Second-Best” Contract This contract maximizes the principal’s expected profit subject to the following constraints: The agent’s utility is at least as high if she pursued her next best alternative. The contract induces the agent to provide the principal’s desired level of effort.

26 Simple Way of Representing the Second-Best W = A + BX W is the agent’s compensation A is the agent’s fixed component of her compensation B represents the extent to which compensation is tied to performance When B is large, it is known as a higher-power performance incentive X is a measure of performance

27 Compensation for Performance (B) The optimal value of B is a function of the following: The agent’s risk aversion The agent’s effort aversion The marginal contribution of effort to profitability The noisiness of the performance measure

28 Limited Liability When an agent is unable to pay penalties for poor performance, the agent is said to have limited liability. When an agent has limited liability, the principal may have to pay an efficiency wage. The efficiency wage is the amount of compensation that induces the agent to take the efficient action.

29 Sorting When there are multiple potential agents, then a contract may need to be written in such a way to systematically influence the characteristics of the agents. This is known as sorting. Sorting relates to structuring the incentives in the contract to obtain the workers that will optimize the principal’s payoff.

30 Rules of Thumb for Sorting More able and/or risk taking agents prefer pay-for-performance contracts. Low mobility workers prefer schemes that link pay to job tenure. Agents with limited liability are more willing to accept contracts that provide larger rewards for success and large penalties for failure.

31 Complications to the Agency Relationship Multiple Agents and Teams Since monitoring team performance can be difficult, structuring contracts for the agents can be difficult. Multidimensional Agency If an agent is doing unrelated tasks, then a contract needs to take into consideration how to structure the incentives so one task is not unduly put before another task.

32 Subjective Performance Evaluations as Incentives When dealing with incentive contracts, there tends to be a subjective evaluation of performance. These evaluations can come in the form of: 360-degree reviews Management by objective systems Merit rating systems

Degree Reviews This form of evaluation requires an employees supervisor, coworkers, and subordinates to evaluate him over a period of time.

34 Management By Objective Systems This form of evaluation requires the employee and the supervisor to sit down and develop a set of goals for the employee. At the end of a certain time period, the supervisor meets with the employee to evaluate the accomplishment of the goals and the environment in which they were achieved.

35 Merit Rating Systems In these systems, a supervisor allocates a score to the employee for the work that he accomplished. In many cases the supervisor is allocated a certain amount of points to allocate to all the employees, which requires the supervisor to give higher points to better employees. These systems often suffer from ratings compression.

36 Problems with Subjective Performance Evaluations Supervisor need proper incentives for them to provide good evaluations. Subjective evaluations can lead to employees wasting resources on influence activities.

37 Promotion Tournaments as Incentives A promotion tournament is where a firm provides an opening at a higher level within the firm that provides higher compensation and requires employees to compete for the position.

38 Advantages to Promotion Tournaments It deals with supervisors who are unwilling to make distinction between employees. They are a form of relative job performance evaluation, i.e., they compare one employee to another.

39 Disadvantages of Promotion Tournaments They may not take into consideration who has the greatest potential in the higher level position. They can cause employees to not work with each other.

40 Efficiency Wages and Threat of Termination as Incentives An efficiency wage is defined as a wage that is high enough to induce a desired level of efforts. Some firms use efficiency wages and a threat of termination to motivate employees to put forth their best efforts. Higher wages with the threat of termination can cause employees to work harder to keep their job and can be used instead of monitoring.

41 Incentives for Teams Many projects that are undertaken by employees require team interaction. Since team-based performance evaluations focus on the output of the team, this implies that the benefits from a particular individual’s actions are shared with the entire team. This potentially causes a free-rider problem.

42 Methods to Alleviate the Free- Rider Problem in Teams Keep teams small. Put team members on multiple projects over time so they can have the opportunity to punish team members who are shirking. Structure teams so each member can monitor what the others are doing.