1. Remuneration & Monitoring n 1. Introduction n 2. Principal-Agent Theory n 3. Do incentives work? n 4. Empirical evidence

2. 1. Background n What is the role of the wage? n (i) Allocation function u In a competitive economy, wages should act as guideposts informing people which occupation to take,…, or how long to stay in school, or when to change jobs… Polachek & Siebert, 1993 n (ii) Social stratification \ cohesion function u custom & practice, fair wages (Marshall, Hicks)

3. (iii) Management tool n Outcomes (I.e. output) depends on worker effort n Workers have free will u effort & specific skills u effort is a bad, higher wages are a good n Firms wish to maximise effort / skill use n Divergence of interests n Informational asymmetries n Workers act opportunistically

4. 2. Theory Principal-agent problem Shareholders Board of Directors CEO, managers Supervisors, workers Profit Pay, growth

5. How does the principal ensure that the agent supplies maximum effort? n Designing the optimal contract u a) available information u b) distribution between managers & workers u c) attitudes to risk of principal & agent n 1. Perfect information F effort & other factors affecting output (Q) are observable & measurable F no agency problem F contract: Q = f(e); if Q is produced, worker paid W F no monitoring by principal

6. 2. Symmetric information n Assume F Q = Q(e, ) F is a random (stochastic) variable n reflects state of nature F weather F breakdowns, supply problems F Macroeconomic conditions n = unobservable n Q is therefore stochastic - output is uncertain - See Table 1 n Assume that is known to worker/firm

7. Table 1 Output when e and vary A) Uncertainty of outcome! B) If is known, a contract specifies e 1 if ave and e 2 otherwise; C) What should W be?

8. Wages and attitudes to risk n Fixed wage - principal bears the risk n Variable wage - risk sharing n Should the risk be shared? u Depends on attitude to risk e.g. F risk averse managers F risk neutral shareholders F shareholders should bear all the risk. Why?

9. 3. Risk, uncertainty & asymmetric (imperfect) information n (i) is unknown n (ii) the effect of e and on Q cannot be determined n (iii) …but effort is known to the worker n Paying a wage conditional on e may not lead to Q max n Why?

10. 3. Optimal contract - incentive to deliver e 1 n Offer a contract to maximise expected F E{ [(Q(e, ) - w(Q(e, ))]} n Subject to (a) workers optimal level of effort F E{u[e,w(Q(e, ))]} F i.e.incentive compatibility constraint F nb if bad then e 1 may still result in low wage i.e. risky n And (b) the participation constraint

11. The participation constraint n Utility associated with a contract u* F E{u[e,w(Q(e, ))]} u* n Thus n If workers are risk averse, what type of contract will maximise effort and hence Q? n i.e. output = 3,000 rather than 1,000

12. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 u1u1 High output 1 Low output W=f(Q) Q=f( )

13. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 u1u1 High output Low output W=f(Q) Q=f( ) a b

14. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 High output Low output W=f(Q) Q=f(, e) w0w0

15. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 High output Low output W=f(Q) Q=f(, e) w0w0 a b c

16. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 High output Low output W=f(Q) Q=f(, e) w0w0 a b c u1u1 w1w1

17. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 High output Low output W=f(Q) Q=f(, e) w0w0 a b c u1u1 w1w1 r

18. Figure 2: Optimal contract for worker A YAYA XAXA Y=X certainty line u0u0 High output Low output W=f(Q) Q=f(, e) w0w0 a b c u1u1 w1w1 r fixedVariable

19. 3. Do incentives work? n Yes, Old Pay versus New Pay n Old pay systems F job evaluated grade-wage structure F pay = f(time, seniority, job characteristics) n New Pay systems F Pay related to firms strategy F Flexible & variable pay systems F Higher pay for workers with more competence i.e. skills & knowledge

20. Types of incentive scheme n (i) Performance-related pay n (ii) Piece rates: w = f(Q) n (iii) Commission on sales n (iv) Group-based PRP I.e. bonus systems (US = gainsharing) n (v) Profit sharing