1. D. Internal Organization of the firm
1. Agency and performance measurement
1.1. The Principal/Agent framework
1.2. Costs of tying pay to performance
1.3. Selecting performance measures
2. Incentives in firms
2.1. Implicit incentive contracts
2.2. Incentives and teams
2.3. Career concerns and long term employment
2.4. Incentives and decision making in organizations

2. 1. Agency and Performance Measurement
1.1. The Principal/Agent framework
1.2. Costs of tying pay to performance
1.3. Selecting performance measures

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

4. Typical Principal/Agent Situations
Subordinate
Manager
CEO
Shareholder
Lawyer
Litigant
Agent
Principal

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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

11. Numerical Example 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

12. 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

13. 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

14. 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

15. 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)

16. 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

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

18. The Downside of Pay-for-Performance
If employee is engaged in multiple tasks he/she may focus on task that brings more reward
Typical performance measures may not capture all aspects of performance

19. 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

20. 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

21. 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

22. Risk Sharing – Numerical Example
Assume certainty equivalent
measures risk aversion
Higher means lower certainty equivalent wage
E(wage)= Expected value of wage payment
Var(wage)= Variance of wage payment

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

24. 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

25. 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

26. 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

27. 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

28. 2. Incentives in Firms 2.1. Implicit incentive contracts
2.2. Incentives and teams
2.3. Career concerns and long term employment
2.4. Incentives and decision making in organizations

29. Incentive Mechanisms Implicit contracts Subjective evaluation
Proportion tournaments
Threat of termination

30. 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

31. 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 event unforeseen conditions preclude the payment of the expected rewards

32. 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

33. 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

34. 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

35. 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

36. Promotion Tournaments
Probability of promotion depends on effort
Wage increase
Cost of effort
Each contestant will maximize

37. 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

38. 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

39. Promotion Tournaments
“Winner-take-all” reward counteracts ratings compression
Tournaments work as relative performance evaluation

40. Disadvantage of Tournaments
Best performance in one level needs not indicate skills needed for the next level
Tournaments can encourage sabotage

41. 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

42. 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

43. Efficiency Wage To make employees not shirk, the firm can
Increase p
Increase w
Pool of unemployed workers provides incentives for the employed

44. Efficiency Wages
Efficiency wages are useful when monitoring is difficult
Non-wage benefits will make the jobs more valuable and have an incentive effect

45. Efficiency Wages
“At-will employment” lowers the efficiency wage needed to provide the incentive to not shirk
If the legal environment makes firing harder efficiency wage has to increase
If firing is harder firms may choose alternate means of providing incentives

46. 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

47. 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)

48. 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

49. 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

50. 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

51. 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

52. 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

53. 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”

54. 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)

55. 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

56. 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

57. 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

58. 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

59. 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