1. PowerPoint Slides © Michael R. Ward, UTA 2014

2. Organizational Size A Short History Parallel History
Econ 5313
Organizational Size
A Short History
Middle Ages ( ) – sole craftsman had shop downstairs
Early Industrial Revolution ( ) – cottage industry had handful of workers (Smith’s Pin Factory)
Latter Industrial Revolution ( ) – Rise of the mills with workers
Early Industrial Age ( ) – Factory system with 100-1,000 workers per plant
Later Industrial Age ( s) – Multi-plant firms with up to 100,000+ workers
Information Age (~1960s-) – Smaller firms and smaller worksites
Parallel History
Large scale agriculture – plantations with up to 1,000 slaves
Military – army with up to 30,000 pseudo-slaves

3. Interpretation for Structure
Econ 5313
Interpretation for Structure
Pre-Industrial Society
Where there were economies of scale (e.g. plantations and military), a rigid and centralized decision making process was in place
Otherwise, craftsman was worker/owner
Industrialization Process
New technologies with economies of scale
Relevant information was increasingly collected by at lower levels
Good decisions often require line workers to exercise discretion
How to align goals of worker with goals of firm so that good decisions result?

4. Auction Service International
Econ 5313
Auction Service International
Auction Service International (ASI) employed art experts to convince owners of valuable art to use auction services to sell their artwork
The auction house profited by charging the art owners a percentage of the sell price at auction
This percentage was negotiated by the young art experts
The negotiated “commission” rates were supposed to be between 10 and 30%, but were consistently low, near 10%
The CEO of ASI began investigating this phenomenon and found that the art experts were “trading” low prices for kickbacks from the art owner
What are two possible solutions for this problem?

5. Principal-Agent Model
Econ 5313
Principal-Agent Model
When studying firm-employee relationships we use principal-agent models
A principal wants an agent to act on her behalf
Agents often have different goals and preferences that make acting in the principal’s interest costly
The auction house is a principal; the art expert is an agent
“Office Space” scene

6. Principal-Agent Model
Econ 5313
Principal-Agent Model
Agents and Principals have different incentives
The principal must manage the incentive conflict, which comes down to two problems:
Adverse selection: the principal has to decide which agent to hire
Moral hazard: once hired, the principal must find a way to motivate the agent
Both problems are caused by asymmetric information:
Adverse selection implies that only the agent knows his “type”
Moral hazard means that only the agent knows his effort level
The costs of addressing moral hazard and adverse selection are known as agency costs, because they are often analyzed by principal-agent models

7. Econ 5313
Reducing Agency Costs
A principal can reduce agency costs if she gathers information (reduces information asymmetry)
about the agent’s type (adverse selection)
about the agent’s actions (moral hazard)
Information gathering:
To mitigate adverse selection problems, firms can run background checks on agents before they are hired
To mitigate moral hazard problems, firms can monitor an agent’s behavior while working
This difference in timing leads to the characterization that adverse selection is a pre-contractual problem, while moral hazard is a post-contractual problem

8. Econ 5313
Incentive Pay
Incentive pay can help align the incentives of employees (agents) with the goals of the organization (principal)
For example, if harder work leads to higher sales, then create incentives by tying the employee’s reward to sales performance, e.g., with a sales commission
But incentive pay also imposes risk on agents
Commissions mean a portion of an agent’s compensation is dependent on factors beyond the agent’s control, e.g., weather
Agents must be compensated for taking on this additional risk
So, incentive compensation represents a tradeoff:
Does the benefit (harder work by agent) outweigh the cost (extra compensation for bearing risk)?

9. Decision Making Problems
Econ 5313
Decision Making Problems
In an ideal organization
Decision-makers have all the information necessary to make profitable decisions
And the incentive to do so
When designing an organization, you should consider how to structure the following three items:
Decision rights: who should make the decisions?
Information: is the decision-maker provided with enough information to make a good decision?
Incentives: does the decision-maker have the incentive to do so?
Incentives are created by linking:
A performance evaluation system
A reward system

10. Econ 5313
University Faculty
Ex Faculty are evaluated annually on: 1) research 2) teaching 3) service
Research – Ranking system of publishing in quality journals, grants, etc. is rather informative
Teaching – Student evaluations are not very informative
Service – Committee membership activity
Linkage to pay?
Budget Freeze?
Chair allocates budget increase proportionally?
Outside offer!
Elaborate evaluation system is useless if not linked to a reward system
(Also, reward system useless if evaluating wrong metrics)

11. Centralize versus Decentralize
Econ 5313
Centralize versus Decentralize
How should decision rights be assigned?
Decentralize decision making: move decision rights down in the hierarchy, closer to those with better information
Centralize decision making: move decision rights up in the hierarchy, closer to those with better incentives
Information must flow to decision maker
Information is usually decentralized
If you centralize decision-making, find a way to transfer information to those making decisions
Compensate good decisions
Incentive are usually better higher up the hierarchy
If you decentralize decision-making authority, you should also strengthen incentive-compensation schemes

12. Decision Rights Tradeoffs
Econ 5313
Decision Rights Tradeoffs
Is it easier to get the information to flow from its source to a different decision maker?
Or is it easier to create incentives for the one with the information to make good decisions?
Or is it easiest to have someone else make the decision?
Depends on specific context
Faculty Example
Extremely decentralized – e.g., research topic, course content
But weak incentives
Prediction: deadwood

13. Performance Evaluation
Econ 5313
Performance Evaluation
Informal: using subjective performance evaluation
Formal: using objective measures such as sales or accounting profit, stock price, relative performance metrics
Rewards: Decide how compensation is tied to performance evaluation
Reward good performance and/or penalize bad performance
Ex Bonus, increased probability of promotion, faster promotion , first choice in scheduling

14. Multiple Objectives Evaluation of performance on multiple objectives
Econ 5313
Multiple Objectives
Evaluation of performance on multiple objectives
Ex Convenience store manager gets bonuses tied to 10 meeting formal criteria (e.g., sales targets, promotional product sales, low employee overtime, low employee turnover, low stock-outs, etc.)
Impossible to meet all but you earn bigger bonus for meeting more objectives
Do you strive for between 90% and 110% of all objectives or 101% of some and 0% of others?
Faculty Example – If outside offers based solely on research output, do I care about teaching?

15. Sales versus Marketing
Econ 5313
Sales versus Marketing
Sales and marketing divisions often have incentive conflict
Sales wants to maximize revenue, i.e., all sales where MR > 0
Marketing wants to maximize profit, i.e., all sales where MR > MC
In other words, sales prefers a higher level of sales and a lower price than does marketing
Ex A large telecommunications equipment company that serves government agencies that buys telecom equipment
Sales people want to bid more aggressively to make sure that they win the contract (they care about maximizing sales)
Marketing wants the sales agents to bid less aggressively, so that when they do win, the contracts are more profitable (they care about maximizing profit)

16. Sales versus Marketing
Econ 5313
Sales versus Marketing
Two solutions to marketing versus sales:
Centralize sales decisions to marketing; and try to transfer enough information to marketing managers so they know how aggressively to bid (car salesman/manager?)
Decentralize sales decisions (keep decision rights with the sales people) and change incentives but they have no decision rights over price (shoe salesman)
Instead of a 10% commission on revenue, give sales people a 20% commission on profit, (revenue neutral if the contribution margin is 50%)
Ex Rockford Files

17. Threshold Compensation
Econ 5313
Threshold Compensation
How well do threshold compensation schemes work, e.g., a bonus if you open hit a target sales number?
How well do high-powered sales commissions work, e.g., 5% commission for sales of $1M; 10% commission on sales of $2M, work?
Ex Pass Comps with “Incredible Marginality”

18. Econ 5313
Group Incentives
Group incentives are usually weaker than individual incentives due to free-riding
Often it is impossible to discern the contributions of each making any incentive contract a group incentive contract
Ex Incentives for teachers
One incentive scheme was for groups of teachers teaching the same subject within a grade and school
Linking pay to performance of students across classes has been shown to improve academic performance (Imberman and Lovenheim, 2012)

19. Teacher Group Incentives
Econ 5313
Teacher Group Incentives
Why base incentives on teacher groups and not individual teachers?
Student performance data available for each teacher
But individual teacher incentives do not seem to work
Possible explanations for better performance with group incentives:
Avoids teachers “cherry-picking” students
Sorts students into different classes – based on student ability or, say, unruliness
Captures spillovers within the teacher group
Demonstrates possibilities to other teacher groups

20. Econ 5313
Franchising
Incentive conflict exists between franchisors (McDonalds) and its franchisees (local businessmen)
McDonalds wants big franchise fees and high quality at franchisees to protect its reputation
Franchisees want smaller fees and lower quality (cheaper)
Stores are both company-owned and franchisees
In a company-owned store, both adverse selection and moral hazard are concerns – managers don’t work as hard as owners and salaried manager positions might attract lazy workers
Franchisees have bigger incentive to work hard (because they are the “residual claimants” of profit) but have to have their quality monitored

21. Franchising Why both company-owned and franchisees?
Econ 5313
Franchising
Why both company-owned and franchisees?
Where would you expect to see either?
Where is demand greatly affected by manger effort?
Company run stores tend to be located in tourist areas
Like at freeway off-ramps or inside amusement parks

22. Hotel Employees Ex Confessions of a Hotel Maid
Econ 5313
Hotel Employees
Ex Confessions of a Hotel Maid
“I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray-and-wipe kind of day… After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn't tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots… I apologize to you now if you ever stayed in one of my rooms. You deserved better. But if housekeepers were paid more than minimum wage — and the tips were a bit better — I might have cleaned your toilet rather than just flushed it.”
How do you motivate this worker?

23. Hotel Employees Motivate maids with informal incentive compensation
Econ 5313
Hotel Employees
Motivate maids with informal incentive compensation
It is possible to implement hiring practices characterized by low initial pay with more bonuses and more merit based pay
Freedman and Kosová find that, relative to company owned hotels, franchise operations rely more on such hiring practices
So, to address worker shirking you need to address store manager shirking
Franchising can help solve this problem

24. From the Blog Chapter 21 High Powered Incentives and Sales Bunching
Econ 5313
From the Blog
Chapter 21
High Powered Incentives and Sales Bunching
DC Teacher Incentives
Doing Good
Wall Street reacts to Steve Balmer stepping down

25. Econ 5313
Main Points
Principals and Agents typically have different goals that cause an incentive conflict
This kind of incentive conflict is called an “agency problem” and leads to moral hazard and adverse selection
The costs of the agency problem fall when the principal is better informed but sometimes the information is too costly
Fixed pay and monitoring
Incentive pay with little monitoring
Hybrid

26. Econ 5313
Main Points
Decision makers should have necessary information and appropriate incentives
Decentralizing usually requires stronger incentives at the fringe
Centralizing usually requires enhanced information flow
Analyze agency problems with three questions:
Who is making the bad decision?
Do they have enough information?
Do they have strong enough incentives?
Alternative solutions involve:
Changing decision rights?
Transferring information?
Changing incentives?