Remuneration

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Remuneration Monitoring

• 1. Introduction
• 2. Principal-Agent Theory
• 3. Do incentives work?
• 4. Empirical evidence

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1. Background

• What is the role of the wage?
• (i) Allocation function
• 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
• (ii) Social stratification \ cohesion function
• custom practice, fair wages (Marshall, Hicks)

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(iii) Management tool

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

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2. Theory

• Principal-agent problem

Profit
Shareholders
Board of Directors
Pay, growth
CEO, managers
Supervisors, workers
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How does the principal ensure that the agent
supplies maximum effort?

• Designing the optimal contract
• a) available information
• b) distribution between managers workers
• c) attitudes to risk of principal agent
• 1. Perfect information
• effort other factors affecting output (Q) are
  observable measurable
• no agency problem
• contract Q f(e) if Q is produced, worker paid
  W
• no monitoring by principal

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2. Symmetric information

• Assume
• Q Q(e, ?)
• ? is a random (stochastic) variable
• ? reflects state of nature
• weather
• breakdowns, supply problems
• Macroeconomic conditions
• ? unobservable
• Q is therefore stochastic - output is uncertain -
  See Table 1
• Assume that ? is known to worker/firm

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Table 1 Output when e and ? vary
A) Uncertainty of outcome! B) If ? is known, a
contract specifies e1 if ?ave and e2 otherwise
C) What should W be?
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Wages and attitudes to risk

• Fixed wage - principal bears the risk
• Variable wage - risk sharing
• Should the risk be shared?
• Depends on attitude to risk e.g.
• risk averse managers
• risk neutral shareholders
• shareholders should bear all the risk. Why?

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3. Risk, uncertainty asymmetric (imperfect)
information

• (i) ? is unknown
• (ii) the effect of e and ? on Q cannot be
  determined
• (iii) but effort is known to the worker
• Paying a wage conditional on e may not lead to
  Qmax
• Why?

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3. Optimal contract - incentive to deliver e1

• Offer a contract to maximise expected ?
• E?(Q(e, ?) - w(Q(e, ?))
• Subject to (a) workers optimal level of effort
• Eue,w(Q(e, ?))
• i.e.incentive compatibility constraint
• nb if ?bad then e1 may still result in low wage
  i.e. risky
• And (b) the participation constraint

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The participation constraint

• Utility associated with a contract ? u
• Eue,w(Q(e, ?)) ? u
• Thus
• If workers are risk averse, what type of contract
  will maximise effort and hence Q?
• i.e. output 3,000 rather than 1,000

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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?)
YA
YX
Low output
u1
u0
XA
High output1
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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?)
YA
YX
Low output
a
u1
b
u0
XA
High output
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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?, e)
YA
YX
Low output
w0
u0
XA
High output
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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?, e)
YA
YX
Low output
b
a
c
w0
u0
XA
High output
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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?, e)
YA
YX
Low output
b
u1
a
c
w1
w0
u0
XA
High output
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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?, e)
YA
YX
Low output
r
b
u1
a
c
w1
w0
u0
XA
High output
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Figure 2 Optimal contract for worker A
certainty line
Wf(Q) Qf(?, e)
YA
YX
Low output
r
b
u1
a
c
w1
w0
u0
XA
fixed
Variable
High output
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3. Do incentives work?

• Yes, Old Pay versus New Pay
• Old pay systems
• job evaluated grade-wage structure
• pay f(time, seniority, job characteristics)
• New Pay systems
• Pay related to firms strategy
• Flexible variable pay systems
• Higher pay for workers with more competence i.e.
  skills knowledge

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Types of incentive scheme

• (i) Performance-related pay
• (ii) Piece rates w f(Q)
• (iii) Commission on sales
• (iv) Group-based PRP I.e. bonus systems (US
  gainsharing)
• (v) Profit sharing