Chapter 12 - Performance measurement and incentives

Question 1

principal-agent relationship/agency relationship

Answer 1

occurs when one party (agent) is hired by another (principal) to take actions or make decisions that affect the payoff of the principal

Question 2

difficulties in agency relationships can arise when two conditions are met:

Answer 2

• objectives of principal and agent are different

- action taken by the agent or the information possessed by the agent are hard to observe

Question 3

objectives of principal and agent are different

Answer 3

• the typical principal would like to maximize the difference between the value it receives as a result of the agent’s actions and any payment it makes to the agent
• however, the agent does not directly care about the value generated for the principal, rather about the value it generates for itself

–> interests are normally not aligned

Question 4

action taken by the agent or the information possessed by the agent are hard to observe

Answer 4

• if actions and information are easily observable, then the principal can write a complete contract with the agent that aligns their interests
• contracting can be hindered by hidden action or information

Question 5

hidden action or information

Answer 5

things known by the agent but not by the principal

Question 6

monitoring can help, but does have some significant limitations

Answer 6

• it is often imperfect
• hiring monitors can be costly
• hiring a monitor often introduces another layer to the agency relationship

Question 7

performance-based incentives can take two forms:

Answer 7

• monetary rewards such as year-and bonuses or stock options

- non-monetary rewards such as vacations or status rewards

Question 8

not feasible compensation scheme

Answer 8

• employee’s effort level is represented by “e” (hours the employee puts forth HIGH effort)
• e represents a hidden action and cannot be included in a contract
• employee is willing to put forth some high efforts regardless of compensation but will exert extra effort only if compensated in some way

Question 9

the cost function is convex

Answer 9

extra effort becomes more and more costly as the employee’s effort level increases

Question 10

feasible compensation schemes

Answer 10

scenario 1: straight salary matches the market wage of $1000/week

• employee’s payoff of net effort costs: $1000 - c(e)
• as pay does not depend on sales, employee is unwilling to put in more than 40 units of effort
• employee’s 40 units of effort result in $4000 sales, while wage paid is $1000; firm’s profits are $3000

scenario 2: firm offers a salary of $1000/week + 10% sales commission

• each unit of effort produces an extra $100 of sales
• employee’s payoff: $1000 + 0.1*(100e) - c(e)
• employee will increase effort until the marginal benefit of effort is equal to the MC
• the marginal cost of effort is the slope of the effort curve; it becomes more and more costly for the employee to exert additional effort

Question 11

several key points about performance-based incentives

Answer 11

• the slope of the relationship between pay and performance provides incentives for effort
• the firm earns a higher profit when it offers the salary + commission job
• the firm can do even better if it sets a higher commission rate
• performance-based pay can help resolve hidden information problems

Question 12

two potentially big problems with performance based incentives

Answer 12

• if the performance measure is affected by random factors that are beyond the employee’s control and therefore subject the employee to unwanted risk
• if the measure fails to capture all aspects of desired performance

Question 13

risk averse

Answer 13

a risk averse person prefers a safe outcome to a risky outcome with the same expected value

Question 14

certainty equivalent

Answer 14

the certain amount that makes the decision maker indifferent between taking the risk and taking the certain payment. the smallest certain amount the decision maker would be willing to accept in exchange for the risky payoff

Question 15

risk premium

Answer 15

the cost to the decision maker of having to bear the risk of an uncertain outcome (expected value of a risk - decision maker’s uncertainty equivalent)

Question 16

three key properties (risk …)

Answer 16

• different decision makers will have different certainty equivalents for the same risk
• for a given decision maker, the certainty equivalent is lower (risk premium is higher) when the spread or variability payment is greater
• when choosing between two risky outcomes, a decision maker will select the one with the higher certainty equivalent

Question 17

risk sharing

Answer 17

the risk neutral party can offer the risk-averse party an amount of money somewhere between the expected value and the risk-averse party’s certainty equivalent –> both will be better off accepting this transaction

Question 18

tying pay more closely to measure performance increases the variability of the employee’s compensation

Answer 18

makes job less attractive and implies that the firm has to pay higher overall wages in order to attract the employee

Question 19

stronger incentives are called if:

Answer 19

• the employee is risk averse
• the variance of measured performance is lower
• the employee’s marginal cost of effort is lower
• the marginal return to effort is higher

Question 20

firms can reduce the risk that employees are exposed to by selecting

Answer 20

performance measures that are subject to as little randomness as possible and investing in reducing the randomness in available measures

Question 21

use of pay-for-performance incentives will cause employees to focus on

Answer 21

aspects of performance that are reflected in the measure and to neglect aspects that are not reflected in the measure ( = multitasking)

Question 22

three features of good performance measures

Answer 22

• one that is less affected by random factors –> tie pay closely to performance without introducing much variability into the employee’s pay
• one that reflects all the activities the firm wants undertaken –> use strong incentives without pulling the employee’s attention away from important tasks
• one that cannot be improved by actions the firm does not want undertaken –> offer strong incentive without also motivating counterproductive actions

Question 23

whether to use “absolute” or “relative” measures of an employee’s performance

Answer 23

• relative measure is constructed by comparing one employee to another

–> can exacerbate multitask problem (employee taking action that reduce productivity of another)

• must weigh the possible reduction in risk against potential increases in counterproductive actions

Question 24

choice between “narrow” and “broad” performance measures

Answer 24

• narrow measure example: number of pieces of output produced by an individual
• broad measure: accounting profits of the plant where the employee works (advantage of rewarding employees for helping co-workers; likely to be subject to more random factors)

Question 25

implicit incentive contracts

Answer 25

• primary advantage: range of performance measures can be incorporated because they do not need to be verifiable/enforceable to a third party

Question 26

360-degree peer reviews

Answer 26

an employee’s supervisor, co-workers, subordinates are all asked to provide information regarding that employee’s performance

Question 27

management by objective systems

Answer 27

an employee and a supervisor work together to construct a set of goals for the employee. at the end of the specified period, they review on the performance of those goals

Question 28

merit rating systems

Answer 28

employees are given numerical scores. often supervisors need to allocated a fixed pool of points to be allocated among employees

Question 29

three costs to incorporating subjective performance assessments

Answer 29

• rating compression: supervisors may find it personally unpleasant to reward some employees but not others and give all subordinates an average (weakens incentives)
• subject to influence activity; established good personal relationships with supervisors
• may be noisy; implementation requires a deft balancing of benefits and costs

Question 30

promotion tournament

Answer 30

a set of employees competes to win a promotion, and the “prize” is usually a substantial increase in compensation

Question 31

advantages of using tournaments

Answer 31

• they circumvent the problem of supervisors who are unwilling to make sharp distinctions among employees
• they are a form of relative performance evaluations –> any common random factors that affect performance are netted out

Question 32

disadvantages of using tournaments

Answer 32

• individual who is best at performing a lower-level job may not be the right choice for a higher-level job
• relative evaluation rewards employees for taking actions that hamper the performance of other employees

Question 33

efficiency wage

Answer 33

a wage high enough to motivate effort

Question 34

free-rider problem

Answer 34

individuals may not take actions that maximize overall welfare

Question 35

firms can mitigate the free-rider problem in multiple ways

Answer 35

• keep the team small
• allow teams to work together over time –> repeated interaction allows them to make their current actions depend on what other team members did in the past (tit-for-tat solution)