Lecture 5 - Agency Theory

Question 1

Types of Incentive Pay

Answer 1

• Gainsharing / group incentives
  o Pay tied to gains in measures of group “success”
  o E.g., tip pooling
• Profit-sharing
  o Pay tied to profits of firm
• Efficiency wages
  o Paying employees a “premium” – overpay compared to market pay
  o Reduces the probability of “shirking” because it’s costly to get caught and fired
  o Can reduce monitoring costs
  o Reduces turnover and saves on hiring/training costs
• Piece rates
  o Pay tied to amount of output produced
  o Increases risk on employees
   Risk premium
  o Self-selection on productivity & risk aversion

Question 2

Advantages and disadvantages of piece rates

Answer 2

Advantages:
* Increases productivity

Disadvantages
* May decrease quality
* Decrease in willingness to help others
* Increased monitoring costs

Question 3

Effects of piece rates

Answer 3

• Average output per worker increased
• Part of the increase in output was caused by employee turnover
• Ambitious/able workers are more likely to stay at the firm than lazy
• New hires are more likely to be ambitious/able
• Increase in profits & wages

Question 4

CEO compensation

Answer 4

• Rewarded based on contribution to performance
• Higher risk of being fired  high risk premium
• International generalists  higher bargaining power
• Agency perspective: align CEO interest with shareholders’
• The public disapproves of high CEO salaries

Question 5

Mechanisms that handle agency problem

Answer 5

• Controlling the CEO
  o Board of directors
  o Shareholder activism
  o External forces
• Incentivize CEOs
  o Salary increases
  o Performance bonuses
  o Stock options
  o Pension plans
  o Risk of dismissal

Question 6

When is piece rates useable

Answer 6

Piece rates is only applicable when
- output is independent
- easily observable/easy to monitor.