Incentive Contracts

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Incentive Contracts
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A story ...

• Your car breaks down near an outback town. After
  beginning work on the car a mechanic might tell
  you that you will need a new radiator and it will
  cost 500. You cannot tell if this is true or
  not.
• When those with critical information have
  interests different from those of the decision
  maker, they may fail to report completely and
  accurately the information needed to make good
  decisions.
• If the mechanic is lying, your interests and
  those of society are harmed -- resources are
  wasted.

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A quick fix ...

• Suppose you buy the radiator then 200 kilometers
  down the road you have the same problem. The new
  radiator was not installed correctly and it will
  cost you time and money to repair it.
• When buyers cannot easily monitor the quality of
  the goods or services that they receive, there is
  a tendency for some suppliers to substitute poor
  quality goods or to exercise too little effort,
  care, or diligence in providing the services.
• Again there is a loss in resources. More time for
  repairs etc.

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Motivating Agents

• Why do you need to motivate agents?
• Conflict of interest
• Risk of opportunism or moral hazard
• This is the agency problem
• Previous lectures ownership as a means of
  motivation when actions non-contractible
• Some contexts actions are partly observable (or
  verifiable)

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Moral Hazard

• Term comes from the insurance industry
• Form of ex post opportunism differences in
  information distort an agents incentives after
  the transaction is made
• Examples
• Health Insurance
• Insured -- more willing to eat poorly etc.
• Doctors -- more willing to prescribe treatment
• Home Insurance -- less willing to install alarms
  and better locks
• Car Insurance -- take more risks while driving

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Controlling Moral Hazard

• Ownership
• Monitoring
• Bonding
• Incentive Contracts

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Principal-Agent Analysis

• Basic model two parties
• Principal on whose behalf work is done by
• Agent who does the work

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In-Class Exercise

• Incentives for Real Estate Agents

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Details

• You have a house for sale that may be valued
  anywhere between 475,000 to 525,000. The
  average valuation you have received is 500,000.
• How should you structure a real estate agents
  commission?
• E.g., use a flat 2 of the sale price
• E.g., pay 20 of the increment above 500,000

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Empirical Evidence

• Levitt Syverson (2005)
• Look at house prices of estate agents and compare
  this with what they sell their own house for
• Own houses sell for 3.7 more and are on the
  market for 9.5 extra days (or 10 longer)
• Distortion worse when housing stock is
  heterogeneous, less use of internet and where
  buyer does not have their own realtor.

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Incentive Contracts

• Reward agents based on realised performance
• How do you observe performance if cant observe
  effort directly?
• Indirect measure effort improves some outcomes
  (e.g., in maintenance, reward on frequency of
  machine breakdowns)
• Use other information to improve knowledge of how
  effort affects outcome

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Transaction Cost

• Rewarding agent based on outcomes means they bear
  some uncontrollable risk
• What if principal is less risk adverse than the
  agent?
• Need to compensate them for this cost
• If risks large, may not be worthwhile (value
  maximising) to provide incentives
• Transaction cost comes from misallocation of risk
  bearing
• Dilemma insuring against risk is good but this
  undermines ability to give incentives

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Simple Incentive Contract

• Many incentive contracts
• Wage A BX
• where X is the performance measure, A is a fixed
  wage component and B is a measure of how
  compensation is tied to performance -- e.g., a
  bonus
• Choose A to encourage agent participation and B
  to provide incentives.

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Principles of Incentive Contracting

• Incentive Intensity Principle
• Informativeness Principle
• Monitoring Intensity Principle
• Equal Compensation Principle

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Incentive Intensity Principle

• When is B likely to be high (high powered
  incentives)?
• low agent risk aversion
• low agent effort aversion
• high marginal contribution of effort
• relatively noise-free performance measure

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Applications

• Supermarket managers profitability of local
  outlet depends on store managers staffing and
  stocking decisions (effort important). Profits
  are easy to measure at store level. Contrast with
  managers of fast food outlets who are not
  measured on store profits (unrelated to effort).
• CEO and top manager incentives based on share
  market performance. Their decisions affect this
  while those of others in the organisation do not.

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Informativeness Principle

• In designing compensation formulas, total value
  is always increased by factoring into the
  determinant of pay any performance measure that
  allows a reduction in the error with which the
  agents choices are estimated and by excluding
  performance measures that increase the error with
  which effort is estimated (for example, because
  they are solely reflective of random factors
  outside the agents control).

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Sales Commissions

• z Personal sales effort random element
• Second indicator (y total demand in country).
  Use this to provide a better predictor of effort.

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Comparative Performance Evaluation

• When is it a good idea to base pay on relative
  rather than absolute performance?
• If variation in individual performance measure is
  based more on a common random element, use
  relative performance
• If variation in individual performance measure is
  based more on individual random element, use
  absolute performance

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Monitoring Intensity Principle

• Suppose that the error variance can be reduced by
  devoting resources to its measurement, e.g.,
  Direct monitoring.
• Comparing two contracts, one where pay is more
  sensitive to performance and the other less so,
  we find that more resources are spent on
  measurement for the more sensitive contract
  when the plan is to make the agents pay very
  sensitive to performance, it will pay to measure
  that performance carefully.
• Therefore, incentive intensity and monitoring are
  complements an increase in the marginal returns
  to profitability or a fall in the marginal costs
  of effort leads to more of both.

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Equal Compensation Principle

• If an employees allocation of time or attention
  between two different activities cannot be
  monitored by the employer, then either the
  marginal rate of return to the employee from time
  or attention spent in each of the two activities
  must be equal, or the activity with the lower
  marginal rate of return receives no time or
  attention.
• Example incentives for teachers

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Multi-Dimensional Effort

• Not just more but the right type of effort
• Teachers
• Physicians
• Salespeople rewards sales but at the expense of
  building long-term client relationships
• May be better to remove incentives altogether

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Balancing Incentives

• Research in pharmaceutical industry
• Cockburn, Henderson and Stern note that
  researchers need to do two things - generate
  immediately useful output (patents) and invest in
  fundamental knowledge (conferences etc.)
• Use internal capital market to reward the former
  (funding based on patents) and promotion policies
  on the latter
• Find if have strong incentives in one, have
  strong incentives in the other and vice versa

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Case

• Safelite Auto Glass

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Safelite Glass Corporation

• Located in Columbus, Ohio
• Largest installer of automobile glass in the US
• 1994 CEO Garen Staglin and President John Barlow
  instituted a new compensation scheme for glass
  installers
• A very competitive industry so costs and
  productivity really matters to get prices down
  and response time up

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Previous System

• Paid an hourly wage rate and overtime
• Did not vary with number of windows installed
• Installers job is monitored and they are
  required to meet minimum quality standards
• Managers were worried that installers just did
  the minimum number of windows per week to keep
  their jobs installers thinking about leaving the
  firm might slow work even further

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New System

• Installers would be paid each week the maximum
  of
• Amount they would have made according to the old
  hourly wage system
• A fixed amount per job completed
• The piece rate was set so that an installer doing
  an average number of jobs per week would be
  better off under the old formula
• So enterprising installers could do a lot better

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Outcomes

• Increased productivity per worker
• Number of windows installed per week increased by
  44
• Came from 20 increase in rates on new scheme
• Reduction in turnover among most productive
  workers
• Changed behaviour
• Technicians didnt drive as far for a job
• Checked they had parts at beginning of day
• Maintained tools
• Unit labour costs fell from 44.43 to 35.24 per
  window
• Average compensation per worker rose but
  productivity rose by more
• 2/3s relying on PPP rate and others on
  guaranteed rate

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Issues

• Problem of quality
• Forced to re-installed own work without pay
  before they could take on other jobs
• If not available, transferred PPP pay to other
  installer
• Problem of customer service
• Created League of Superheroes for installers
  achieving high rates, got an extra 0.50 - 2 per
  job (called Power Bucks) for a high customer
  service rating (simple question).

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Morals

• Difficult to use objective performance measures
  to create ideal incentives
• Efficient bonus rates are consequently often
  small
• In multi-task settings, require a balanced set of
  incentives with instruments ranging from cash
  payments to indirect policies such as promotion
• Perhaps subjective performance measures would be
  better