12 - Performance Measurement And Incentives Flashcards
Principal-Agent relationship
- When one party is hired by another to take action or make decisions that affects the payoffs to the principal
- interests and objectives differ
- hidden action or information (hard to observe)
Monitoring
- costly
- complexity to monitor
- add another layer of AP relationship
Alternative: objective performance evaluation
Performance based incentives
When the principal links the agents pay to the value the principal receives (commissions) to align interests and objectives
Effort function
Economic model describing how a hypothetical employee react to incentives.
The employee will increase effort until MC=MR
Characteristics:
- the slope provide incentive for effort but not the absolute level
- higher profit earned when salary + commission
- maximise profit when commission = 100%
- resolve information problem
Cons:
- measure is affected by random factors that are beyond the control of the employee and put him at risk
- measure fails to consider all relevant aspects of performance
Risk averse
- people tend to have diminishing marginal utility for wealth
- the fear of losing is much stronger than the chance of winning
=> dislike jobs that invoke risky pay and the firm must compensate for bearing the risk (random factors)
Certainty equivalent
Amount that makes the decision maker indifferent between taking the certain payement or taking the risk.
3 properties:
- different decision makers have different certainty equivalents
- CE is lower when the spread of variability is higher
- when choosing between risky outcomes will take the one with highest certainty level
Risk premium
Expected value of risk - certainty equivalent
Sharing the risk
Reduce the variability of risk costs
Stronger incentives are called for if
employee is:
- less risk averse
- lower variance
- lost marginal cost
- higher matinal return
Features of a good performance measure
- less affected by random factors
- reflect all the activities the firm wants undertaken
- cannot be improved by actions the firm doesn’t want undertaken
Can be:
- absolute or relative - relative multitasking and counter productive pb
- narrow or broad - broad reward for helping coworkers or for making suggestions that improve plant efficiency but many sources of randomness
Implicit contracts
Are not enforceable by third parties but a firm that reneges on its promises will profit in the ST but damage ya reputation in the LT
Costs of subjective performance evaluation
- rating compression effect: unpleasant to grade son give an average to everybody
- noisy: introduce unwanted variation in compensation
- influence effect: spend too much time winning the supervisor
Promotion tournament
Set of employees compete for a promotion and the prize is usually a substantial increase in compensation.
Advantages:
- counteract rating compression effect in subjective evaluation
- still is a relative performance evaluation => relative ranking
Disadvantages:
- the winner might not be the best fit (lack of competencies)
- encourage actions that hamper their performance of other employees
- depend on the size of the prize
Other types of incentives
- threat of being fired
- efficiency wage = making the job more valuable
Free-rider problem
The mismatch between total benefit to the team and personal benefit to the individual team member => individual may not take actions that maximise overall welfare.
To counteract:
- keep team small
- LT teams, repeated intersections and dependence(recreate risk of social isolation
- vary team assignment
