Agency Relationships and Agency Theory

1
Incentives in Firms
2
Incentive Mechanisms

• Implicit contracts
• Subjective evaluation
• Proportion tournaments
• Threat of termination

3
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
  supervisors assessment

4
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

5
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

6
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

7
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

8
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

9
Promotion Tournaments

• Probability of promotion depends on effort
• Wage increase
• Cost of effort
• Each contestant will maximize

10
Promotion Tournament

• Contestants effort depends on marginal benefit
  of effort
• Firms can increase to make the
  contestants work harder
• Can either raise or reduce

11
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

12
Promotion Tournaments

• Winner-take-all reward counteracts ratings
  compression
• Tournaments work as relative performance
  evaluation

13
Disadvantage of Tournaments

• Best performance in one level needs not indicate
  skills needed for the next level
• Tournaments can encourage sabotage

14
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

15
Efficiency Wages

• If employee keeps the job wagew
• If employee is fired wagew
• Assume cost of effort50
• Probability of detection, employee shirksp
• Employee will not shirk if gt50

16
Efficiency Wage

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

17
Efficiency Wages

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

18
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

19
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

20
Incentive in Teams

• If total benefit from action gt total cost of
  action, it is a value creating action
• Action will not be undertaken only if total
  costgt
• (n number of members in the team)
• Every team member lacks the incentive to take
  valuable actions (free rider problem)

21
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

22
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

23
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

24
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 members abilities
• Firms may rotate members among teams even if
  there is a short run incentive-related cost

25
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

26
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

27
Career Concerns and Long Term Employment

• Career concerns are weak towards the end of ones
  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

28
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

29
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

30
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

31
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