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)
What are some possible solutions for the costs of pay-for-performance?
Delink pay and performance
Redesign jobs to ensure rewards do not lead to neglect of certain tasks
Use subjective performance evaluation along with direct monitoring
What should a good measure have when considering selecting performance measures?
-> Should not have a huge random component
-> Should encourage desirable activities and discourage
undesirable activities
How can we filter out randomness in a worker’s production which is determined by common shocks?
By conditioning payment on the output produced by others as well as a worker’s own
e.g.
Farmers no matter how much effort he puts in, if the weather is terrible, his
output will be low, but so will the output of others
What are the two main measures of performance measures?
The choice could be between narrow measures
(individual output) or broad measures (firm’s profit).
Broad measures reward employees for working with
their colleagues.
Broad measure may be subject to more randomness
than narrow measures.
Do Pay-for-performance Incentives work?
Compensation plans affect the way employees make
decisions.
For simple jobs piece rate compensation improves productivity.
Pay-for-performance reduces performance along
unmeasured dimensions.
Employees at job training agency focus on stronger candidates
at the expense of weaker ones.
What is the evidence of Pay-for-performance?
In settings where the jobs are complex it is difficult to
relate firm wide profitability to the use of pay-for performance.
It is relatively easy to find examples of destructive
effects of pay-for-performance.
What are the differing mechanisms?
- Implicit contracts
- Subjective evaluation
- Proportion tournaments
- Threat of termination
What are Implicit Incentive Contracts?
Explicit incentive contracts are contracts that can be
enforced by a third party.
For many jobs, performance measures are not perfect.
Implicit contracts can work in the form of supervisor’s assessment
( Jobs in which pay is tied to performance through some
predetermined formula are the exception rather than the rule)
What are the advantages of Implicit Incentive Contracts?
->The range of performance measures that can be
incorporated (subjective performance evaluation –
subjective assessments)
- > The supervisor assessment is used as a performance measure (e.g. 360-degree peer reviews, “management by objective” systems, “merit rating”)
- > Supervisors judgements/peer reviews act as arbitrators
What are the disadvantages of Implicit Incentive Contracts?
- “Ratings compression” (giving average grade to all
employees) – weakens incentives - Influence activity (good personal relationship with
supervisors) ⇒ hiding information - Subjective judgements can be noisy
What can firms do to make Implicit Incentive Contracts?
-> ensure that the employees perceive that the firm is acting in accordance with the contract
-> ensure that the performance standards are being applied consistently across the organization
-> communicate clearly with the employees in the event
unforeseen conditions preclude the payment of the expected rewards
What are some general points around Subjective Performance Evaluation?
Assessment takes into account factors that make it easy
or difficult to attain the goals.
Subjective assessments are subject to “influence”
activity.
Firms implement subjective performance evaluation in a
variety of ways.
An employee and a supervisor work together to
construct a set of goals for the employee.
At the end of some specified period, the two meet to
review the employee’s performance on those goals
What is crucial to Promotion decisions?
Subjective evaluations
How do firms identify what actions will lead to promotion?
- General understanding between the firm and its employees ( Don’t state promotion criteria as part of an explicit contract)
- As Edward Lazear and Sherwin Rosen have pointed out, promotion based incentives
often take the form of a promotion tournament
What is a Promotion Tournament?
The contest among workers to be promoted to the next level is like an athletic tournament.
- Promotion tournaments can provide incentives against shirking.
What are some elements of Promotion Tournaments?
- Promotions typically involve marked pay increases.
- Employees have strong incentives to take actions that will enhance their chances of being promoted.
- Promotion criteria are not typically part of an explicit
contract. - Winning in one level gives the winners the chance to
compete in the next level.
What are the advantages of promotion tournaments?
- > “Winner-take-all” reward counteracts ratings compression.
- > Tournaments work as relative performance evaluation.
What are the disadvantages of Tournaments?
Best performance in one level needs not indicate skills
needed for the next level.
Tournaments can encourage sabotage.
What is some evidence for promotion tournaments?
- > In large U. S. firms substantial pay increases are associated with promotions.
- > Wage differentials increase with rank
- > Difference in pay between CEOs and corporate vice presidents is larger when the vice presidents are more numerous.
- > Firms with more vice presidents offer larger “prizes.”
How can the threat of termination be considered a performance incentive?
- > If performance is not satisfactory, worker is fired
- > Firing is a punishment if wages are higher than what is available in the market
- > Firms can also motivate workers by threatening to fire them. Like tournaments, firing is usually based on implicit criteria.
- > ‘Unsatisfactory’ understood by both parties but not carefully defined
How do we identify how hard employees will work? (Efficiency wages) (Set-up)
Suppose that the cost to the employee of working hard is $50 but that:
- > If employee works hard, prob of being retained is 1
- > If employee does not work hard, firm will detect this lack of effort with probability (p), where p<1
What are the differing notations and conditions for the Efficiency wages?
- If employee keeps job
wage = w - If employee is fired
wage = w** - Assume cost of effort = $50
- Prob of detection if employee shirks = p
- Employee will not shirk if p(w - w**) > 50
What are the 2 possible outcomes that shirking leads to?
- With prob 1-p , the employee keeps job and earns w
- With Prob p, the employee is detected, fired and earns w**
What is the expected payoff from shirking?
pw** + (1-p)w
When will the employee will choose to work hard if?
w - $50 > pw** + (1-p)w
p(w-w**) > $50
What can firms do to make employees not shirk?
Increase p or increase w
When are efficiency wages useful?
Efficiency wages are useful when monitoring is difficult.
The pool of unemployed workers provides incentives for the employed
Non-wage benefits will make the jobs more valuable and have an incentive effect.
What does At-will employment do?
lowers the efficiency wage
needed to provide the incentive to not shirk
What happens if the legal environment makes firing harder?
- efficiency
wage has to increase - If firing is harder firms may choose alternative means of providing incentives
When does Incentive in teams work?
-> To achieve the full benefits of team production,
rewards need to be based on team output.
-> With team-based performance measures, benefits from
individuals actions are shared with the team.
-> Some beneficial actions may not be undertaken
When is there a value creating action?
-> If total benefit from action > total cost of action
When an action by undertaken in regards to team incentives?
Only undertaken when,
total cost < (total benefit)/n
n = number of members in the team
What are the problems of incentives in teams?
- Every team member lacks the incentive to take valuable actions (free rider problem)
- Free rider problem is exacerbated if a team member has another task on which he works alone
- Weaker incentives for team-based tasks will result in shift of effort to the individual-based task
What are the solutions to the issues faced by team incentives?
- > Team size can be kept small.
- > Team members can be made to cooperate by allowing them to work together for long periods.
-> Teams can be structured so that team members can
monitor each other
What is the evidence on incentive in teams?
In medical practices, increase in the size of partnerships
lead to reductions in individual productivity.
Larger law firms are less able to control costs compared
with smaller firms
