Agency and Performance Measurement

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Agency and Performance Measurement
Chapter 14
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Aligning individual and Organizational Interests
A stylized fact is that all individuals are
self-interested
A key challenge to managers is how to align
self-interest with the overall organizational
goals
Using incentives in cases where job performance
is complex and multi-dimensional is difficult
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The Principal-Agent Framework
An agent is the person hired by the principal to
take actions that affect the payoff of the latter
Conflicts can arise between principals and agents
because the two parties interests differ
The principals goal is to maximize the
difference between the value received and the
payment made to the agent
The agents goal is to maximize the difference
between the value received from continuing a
relationship with the principal less the cost of
doing so.
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Contracts and Incentives
Complete contracts would solve all problems
concerning incentive alignment --- except they
cant be written
Two key problems that prevent effective contracts
from being written
Hidden actions - agent actions that cannot be
observed or verified by the principal (e.g. best
effort)
Hidden information - situations in which aspects
of the productive environment cannot be observed
by the principal
Explicit versus implicit incentive contract and
performance measures
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How Agents Respond to Performance Measures a
numerical example
The situation
Consider a firm that hires a person to perform a
sales function. The employees effort level is
represented by e. Effort may be considered as the
number of hours the employee works hard. Each
unit of additional effort increases sales by
100. Note the number of hours worked is
observable, the number worked hard is not.
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Consider Two Competing Pay Plans
Plan 1 The employee receives a base salary of
1000 per week, which is the going market rate
Plan 2 The employee receives a base salary of
1000 per week plus a commission of 10 on all
sales
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Plan Analysis
Plan 1
Under this plan, the employ works 40 hours per
week (40 units of effort) and generates 4000 in
sales. The return to the employee is 1000 and
the return to the firm is 3000.
Plan 2
If each unit of effort (an hour worked) yields
100 in sale, the employees payoff is
1000 0.10(100e) c(e)
The effort choice that maximizes the employees
payoff is e 50. This yields a salary of 1500
to the employee, total sale are 5000, and the
profit to the firm is 3500
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1000 0.10(100e)
900 0.10(100e)
50
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Key Implications
It is the slope of the relationship between pay
and performance that provides incentives, not the
level of pay
The firm (principal) can do much better if it
sets a higher commission rate
Performance based pay can help resolve hidden
information costs
Performance based pay is likely to affect the
selection of employees who are attracted to the
firm
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Costs of Tying Pay to Performance
Risk Aversion and Risk Sharing
A risk-averse person prefers a safe outcome to a
risky one with the same expected value
A risk-neutral person is indifferent between a
safe outcome an a risky one with the same
expected value
A risk-seeking person prefers a risky outcome to
a safe one with the same expected value
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An Example
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Certainty Equivalent and Risk Premium
The certainty equivalent is the amount of income
that makes a decision maker indifferent between a
safe and risky outcome
In the previous example the certainty equivalent
is 80,000
The risk premium is the difference between the
expected value of the risky alternative and the
certainly equivalent
In the previous example, the risk premium is
100,000 - 80,000 20,000
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Certainty Equivalent and Risk Premium Key
Properties
Different decision makers will apply different
certainty equivalents to the same risk
For a given decision-maker, the certainty
equivalent is lower (risk premium higher) when
the variability of risk is greater
For a given decision-maker, the certainly
equivalent can be used to compare different risks
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Risk and Incentives
While measured performance depends in part on the
agents (unobserved) actions, it can also depend
on random factors beyond the agents control
If the agent is risk-averse, the principal must
compensate the agent for cost of bearing this risk
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An Example Retail Sales
The basic problem at hand is to set the
commission rate, a, for a risk averse salesperson
working in a retail store
Sales 100e e
where e is a random variable with E(e ) 0 and
variance s2
The salesperson, assumed to be risk averse has a
certainty equivalent for a uncertain income (w) of
E(w) 1/2?Var(w)
where ? is the coefficient of absolute risk
aversion
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Additional Assumptions
The sales persons cost of effort is
and the next best job opportunity offers a CE of
1000 net of effort costs
The firm is considering pay plans with a base
salary of F per week and a commission of a on
sales
Actual sales per week are
F a(100e e)
Expected sales per week are
F a(100e)
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Results
The salespersons certainty equivalent is
CE F a(100e) ½ (e 40)2 - ½? a2 s2
Assume p 3 and s2 10,000, the trade off
between risk and incentives are shown below.
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Implications
This example show the fundamental tradeoff
between incentives and risk in determining how
closely to tie pay to performance, one must weigh
the costs of imposing risk onto risk-averse
employees against the benefits of providing
additional incentives.
In general, stronger incentives are justified
when
The employee is less risk averse
The variance of measured performance is lower
The employee is less effort averse at the margin
The marginal return to effort is higher
Firms can reduce employee exposure to risk by
selecting performance measures that are subject
to as little noise as possible
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Performance Measures That Fail to Reflect All
Desired Actions
The Multitask Principle when allocating effort
among a variety of tasks, employees will tend to
exert more effort toward those tasks that are
rewarded
In other words, the squeaky wheel always gets the
grease!
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Some Key Questions to Ask
What activities can an employee take to improve
measured performance?
How do these activities intersect with those the
firm would like employees to pursue?
Are there activities important to the firm not
reflected in measured performance?
Are there activities that improve measured
performance that the firm does not want employees
to pursue
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Possible Responses to the Multitask Problem
Do not use pay-forperformance incentives
Consider pay-forperformance incentives in job
design
Augment explicit incentive contracts with direct
monitoring and subjective performance evaluation
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Selecting Performance Measures Managing
Tradeoffs Between Costs
Three factors make for a good measure of an
employees performance
Measures that are less affected by random factors
will allow the firm to tie pay to performance
without introducing much variability into the
employees pay
Measures that reflect all of the activities the
firm wants undertaken will allow avoid the
pitfalls of the multitask principle
A performance measure that cannot be improved by
actions the firm does not want undertaken will
allow the firm to offer strong incentives without
motivating counterproductive actions
Meeting all three criteria is rare
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So Do incentives work?
?