Chapter 12 Notes: Performance Measurement and Incentives

1.Principal-agent relationship, or "agency relationship" - agent takes actions/makes decisions that affect the payoff of the principal

a.Issue with any employer/employee relationship but exacerbated with large organizations and especially when ownership is separated from decision-making, as with corporations.

b.Also exists in (1) relationships between a firm and its counsel, or insurance provider, or auditor and (2) between voters/constituents and office holders

c.Not a problem when market signals can work well, especially through markets - prices act as signals (Hayek, 1945)

d.Arise whenever 2 conditions are met:

i.Objectives of principal & agent differ

ii.Actions of, or information know by, the agent are difficult to observe

Example 12.1. Microsoft's bid for Yahoo! & study of fruit pickers' productivity and compensation

Example 12.2. Insurance in the garment industry

Situation when market prices don't work - insurance markets - especially health insurance markets: where prices are high to combat problems of (1) hidden information and (2) moral hazard.

Examples of financial market meltdown in 2007-09

oStarted in housing

oAffected AIG, Fanny May & Freddy Mac and other large insurers

oHit the banking sector

oBanks became wary of lending.

oInability to obtain credit created cash flow difficulties for numerous companies.

One additional problem is that top managers receive bonuses based on short-term profits, not long-term profits - which generally is not in keeping with stockholders' goals. This difference points out the fact that principals want to maximize profit for some "reasonable degree of risk."

2.Coordination issues can be handled by prices & by non-price means, often by determining organizational structure

a.Important when the actions of one individual or team has an impact on others in the firm - when information must be shared. Must decide:

i.How information is to be shared

ii.Who will make the final decisions

b.Structural models:

i.Centralized - very important when coordination is essential to success, as in the military

Weaknesses: (a) communications problems of any sort make response difficult, and (b) may place strain on info-processing capabilities with all info being processed at the top

ii.Decentralized - with info shared among the dispersed decision-makers - the way a university decision-making works

iii.Hybrid of the decentralized model - hiring staff members whose sole purpose is collecting and processing information

iv.Hiring a coordinator from the outside, as with a general contractor on a building project

c.Overall issues

i.Coordination will never be perfect

ii.Coordination problems more difficult in larger organizations

Example: Offshoring in IT tasks problematic when one-on-one and team communication are essential

3.Mitigating agency problems

a.Monitoring - Board of directors monitors CEO; supervisor monitors/audits subordinates, etc.

b.Performance-based incentives - based on the assumption that performance is a function of effort

The firm needs to measure accurately the amount of the desired efforts of its workers - being aware that paying attention to one type of effort [or outcome] may cause employees to not be productive in other dimensions of the job - or worse, their work may become counterproductive concerning these other desired outcomes.

To the extent that performance is a function of effort, the employee will perform "above & beyond" only to the point where the MC_e = MB_e. (See Figures 12.1, 12.2 & 12.3, pp. 405 - 407.)

Under which conditions is this likely to be the WRONG assumption?

i.Paying commissions - What is the relationship between the % of the commission and effort?

For which jobs in our economy is pay tied to commissions?

How can this mitigate the information problem on likely sales from sales effort?

How can this affect the sales portion of the job relative to other portions?

How can/does this work when results are dependent on the work of others?

Example 12.3. Yakima Valley Orchards' experiment with paying by piecework rather than hourly wage

Example. TAMU-CC is now offering prorated pay, below full-pay, for courses not reaching the minimum number of students, for summer school courses.

ii.Raises & bonuses tied to some measure(s) of high or "above average" performance level - "promotion tournaments"

Example 12.4. Problem with tying top employee compensation to market performance - such as stock price

Example 12.5: Quitters never win: Be wary of the disincentive effect on an existing team of hiring a superstar

c.Limiting the set of options for employee decisions/actions - Allowing only a small range for bargaining power, with larger discounts requiring successively higher level of management involved in the decision

d.Team performance incentives - Asking employees to work together in teams. For this to work well, individuals must be able to reap individual rewards for team performance.

Free-rider problem? Team members tend to monitor and decrease free-riding (Knez and Simester, 2001).