Chapter 12 - Performance measurement and incentives Flashcards
principal-agent relationship/agency relationship
occurs when one party (agent) is hired by another (principal) to take actions or make decisions that affect the payoff of the principal
difficulties in agency relationships can arise when two conditions are met:
- objectives of principal and agent are different
- action taken by the agent or the information possessed by the agent are hard to observe
objectives of principal and agent are different
- 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
action taken by the agent or the information possessed by the agent are hard to observe
- 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
hidden action or information
things known by the agent but not by the principal
monitoring can help, but does have some significant limitations
- it is often imperfect
- hiring monitors can be costly
- hiring a monitor often introduces another layer to the agency relationship
performance-based incentives can take two forms:
- monetary rewards such as year-and bonuses or stock options
- non-monetary rewards such as vacations or status rewards
not feasible compensation scheme
- 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
the cost function is convex
extra effort becomes more and more costly as the employee’s effort level increases
feasible compensation schemes
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
several key points about performance-based incentives
- 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
two potentially big problems with performance based incentives
- 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
risk averse
a risk averse person prefers a safe outcome to a risky outcome with the same expected value
certainty equivalent
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
risk premium
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)
three key properties (risk …)
- 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
risk sharing
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
tying pay more closely to measure performance increases the variability of the employee’s compensation
makes job less attractive and implies that the firm has to pay higher overall wages in order to attract the employee
stronger incentives are called if:
- 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
firms can reduce the risk that employees are exposed to by selecting
performance measures that are subject to as little randomness as possible and investing in reducing the randomness in available measures
use of pay-for-performance incentives will cause employees to focus on
aspects of performance that are reflected in the measure and to neglect aspects that are not reflected in the measure ( = multitasking)
three features of good performance measures
- 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
whether to use “absolute” or “relative” measures of an employee’s performance
- 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
choice between “narrow” and “broad” performance measures
- 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)
implicit incentive contracts
- primary advantage: range of performance measures can be incorporated because they do not need to be verifiable/enforceable to a third party
360-degree peer reviews
an employee’s supervisor, co-workers, subordinates are all asked to provide information regarding that employee’s performance
management by objective systems
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
merit rating systems
employees are given numerical scores. often supervisors need to allocated a fixed pool of points to be allocated among employees
three costs to incorporating subjective performance assessments
- 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
promotion tournament
a set of employees competes to win a promotion, and the “prize” is usually a substantial increase in compensation
advantages of using tournaments
- 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
disadvantages of using tournaments
- 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
efficiency wage
a wage high enough to motivate effort
free-rider problem
individuals may not take actions that maximize overall welfare
firms can mitigate the free-rider problem in multiple ways
- 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)
