WEEK 10 - Performance Based Incentives Flashcards
What is Akerloff’s quote regarding a market failure through knowledge asymmetry?
If one of the parties in an exchange or in a
transaction has more complete knowledge than
does the other, this generates an asymmetry
condition which is costly to overcome. Sometimes
markets fail for that reason
What are some of the performance based incentives that are used?
- Sales Commission
- Stock options for executives
- Non-monetary rewards
What does the level of effort depend on?
Depends on marginal benefit and not on level of pay
How can performance based pay allow employees to exploit their private info?
E.g. Salespersons can allocate their time and
effort on most promising customers (using their
private information)
How do we get employees to increase their level of effort?
Employees will increase effort until the marginal benefit of effort is equal to the MC
How do we calculate the level of effort based on just a salary and a salary plus commission?
Salary:
- $1000 salary
Employee payoff net of effort is $1000 - c(e)
Salary + Commission
- $1000 salary
- 10% commission
Employee payoff net of efforts is $1000 + 0.10(100e) - c(e)
(so for each unit of effort employee expects 10% of $100, so will increase effort til MC of effort equal to $10, occurs at e = 50)
Where
e = effort
c(e) = cost of effort
SEE GRAPH AND CALCULATION IN NOTES
What are the problems with using Performance Based Incentives like large commission rates?
performance measure is affected by random factors
measure fails to capture all aspects of desired performance
What is expected value?
Value of each possible outcome (Vi) times the
probability of that outcome (01), summed over all n possible outcomes
SEE IN NOTES
What is Variance?
Variance measures the spread of the probability distribution or how much
variation there is between the actual value and the expected value.
SEE IN NOTES
What is Standard Deviation?
square root of the variance and is a more
commonly reported measure of risk.
SEE IN NOTES
How can you reduce risk without reducing the expected value?
Pooling and sharing
What is Certainty Equivalent?
amount that makes the decision maker
indifferent between taking the risk and taking the certain payment.
What are the main costs of basing pay on measures of performance?
stem
directly from difficulties in measurement, since only in part it
depends on agent’s action.
What is the set up of Holstrom and Milgrom’s model? (SEE MODEL NOTE)
- Firm selects commision rate of α for salesperson
- Salesperson (agent) is risk averse and firm (principal) is risk neutral
(Risk pooled at firm lvl, if firm’s stock publically traded shareholders can diversify portfolios)
What is the calculation for sales in Holstrom and Milgrom’s model?
Sales = $100e + ε bar
Where:
ε bar = random variable with expected value of zero and variance
- Means that:
ε bar positive = high sales
ε bar negative = low sales
What is the calculation for an employee’s uncertain wage outcome in Holstrom and Milgrom’s model?
E(Wage) - (1/2 x pVar(Wage))
Where:
- E(Wage) = Expected value of wage payment
- p measures risk aversion of the employee
- Var (Wage) = Variance of wage payment
What is generally an employee’s cost of effort? (Holstrom and Milgrom)
- 0 to 40 units of effort
- 1/2 x (e - 40) squared (cost of effort)
What is the calculation of an agent’s actual payment?
Holstrom and Milgrom
F + α 100e + ε bar
Where
F is fixed salary
α is commission
100e is employee’s cost of exerting effort level e
Given the random variable of e bar being 0, what is an agent’s expected pay?
(Holstrom and Milgrom)
F + α(100e)
What is the Employees certainty equivalent net of cost of effort?
(Holstrom and Milgrom)
F + α(100e) - 1/2(e -40) squared - 1/2 p α squared variance
Where:
F + α(100e) = Expected commission
1/2 (e -40) = Cost from effort
1/2 p αsquared x variance = Cost for bearing risk
What is the explanation of the calculation behind the employees certainty equivalent net of cost of effort?
(Holstrom and Milgrom)
Employee’s pay increases by 100α for each additional unit
of effort, and a cost of (e – 40)
Equating marginal cost (e – 40) with marginal benefit, the
employee puts in 40 + 100α units of effort
Assuming that ρ = 3 and σ2 = 10,000, the optimal α turns
out to be 0.25
How can the incentive component of pay be made stronger? (Holstrom and Milgrom)
- Employee is less risk averse
- Variance of performance measurement is smaller
- Employee is less effort averse
- Marginal return to effort is higher
What are the limitation of performance measures?
-> Activities important to the firm may not be reflected in
the performance measures.
(Test scores based incentives for teachers will shift their efforts towards developing test taking skills instead of critical thinking
skills)
-> Activities detrimental to the firm may have a positive
effect on the “performance measures.”
(Divisional profits used in incentive plans can lead to conflicts over overhead cost allocation)