10. Incentives Flashcards
why do we need incentive firms?
- markets use price to allocate resources → buying from competitive markets ensures efficiency
- firms use managers to allocate resources → motivating “internal suppliers” to produce efficiently is more difficult
- firms have many decision makes: individual goals (utility maximization) may not be align with the objectives of the firm (profit maximisation)
→ we need incentive to ALIGN INTEREST
conflict of interest (incentive conflicts)
- owner versus manager
→ e.g. work hard or shrink; differing degrees of risk aversion; differential time horizons; salaries and perks - other conflicts
→ e.g. management vs. labour
the role of contracts
- contract controls incentive conflicts
- costless contract: ideal contracts would align interests (minimise incentive conflicts) at no or low cost
- costly contracting and asymmetric information:
• contracts are costly to negotiate, write or administer
• parties to contracts may have asymmetric information (e.g. performance
level, individual characteristics) - contracts define the firm’s organisational architecture
• decision rights
• performance evaluation
• reward systems
organisational architecture
the fundamental problems in designing organisational architecture:
- important information for profit maximising decisions:
- is controlled by many individuals
- may be costly to transfer
- decision makers may have incompatible or misaligned incentives
→ good organisational architecture helps overcome the limitations of decentralised information and misaligned incentives
→ develop a reward and performance evaluation system
organisational architecture
- is created through a explicit contracts (constitution) and implicit institutions (corporate cultures)
- assigns decision rights
- specifies performance measurements
- specifies reward schemes
→ all these cost organisational cost
corporate culture
- culture is the set of explicit and implicit expectations of behavior within the firm
- culture is communicated through slogans, rituals, role models
• architecture shapes employee expectations
• architecture elements are complements
determinants of organisational architecture
business environment
- technology (computers, telecommunication, production methods) - markets (competitors, customers, suppliers) - regulation (taxes, antitrust, international)
→ strategy
- choice of industries - basis for competition (price, quality, service)
→ organizational architecture
- decision-rights assignment - reward system - performance-evaluation system
→ incentives and actions
→ firm value
incentive problems
- interests of the firm owners and the employees are aligned → incentive problem does not exist
- interests differ + the workers’ actions are observable → contract on a worker’s actions can solve the incentive problem
- interest differ + the workers’ actions are unobservable → incentive is needed to align the interests
to avoid incentive problems
sell to individual employee the rights to their production (franchising and managerial buyouts)
limiting factors:
- wealth constraints of employees
- risk aversion of employees
- team production
group incentive pay
is used if:
- output can only be produced by a group (team production function)
- individual performance is difficult or impossible to measure
→ group pay can encourage teamwork and cooperation
→ free-riding might occur
→ in team work, employees have incentives to monitor peers
ways to avoid free-riding
- monitoring by supervisor or by monitors
- peer monitoring
- “sequel team production”
- group bonus for achieving output target
- strengthen group culture and reward exchange of information
- individual contracts
the fundamental problem in individual conractin
asymmetrical information (one partner has more information than the. other)
→ principal-agent theory
→ contract theory
pre-contractual asymmetrical information
- can lead to averse selection
- hidden characteristics (type of agent is unobservable)
→ we need screening or signaling devices
post-contractual asymmetric information
- the ‘delegation problem’: can lead to moral hazard
→ agents have post-contractual motivation to increase their well-being at the expense of the principals
- hidden information (only the agent knows something important)
→ incentive needed to elicit private information
- hidden action (agent’s action / level of effort is non-verifiable)
→ incentive for work effort needed to align interests (motivate agent to make an effort)
paying individuals
- fixed wage: independent of actual output/sales figure
- variable pay: grows with output/sales figure (brought about by agent)
- bonus: additional fixed payment contingent on some event
→ sales figure or output units usually are only imperfectly correlated with “effort”
