Incentives and Employment

Overview: Incentives & employment • Case discussion : 'Outsourcing Sales' • Specialization & Comparative Advantage • Principal-Agent Problems – Pay for performance – Promotion Tournaments • Moral Hazard Set-up : “Outsourcing Sales?” • TV station considers outsourcing sales • Sales company asks variable compensation: – 10% on first $400 million – 5% on part between $400 and $600 million – 2% on sales above $600 million • Sales costs are all variable • TV Station has – $500 million advertising revenue – $450 million fixed costs – $50 million variable cost from sales 1 Outsourcing Sales? Assume first that sales company has same MC as TV station $ 2 Conclusion:“Outsourcing Sales?” • Proposed deal has very poor incentives for sales firm – MR of sales firm is much lower than MR of TV station => it will typically sell many fewer ads, costing TV station revenues • Deal can make sense – If sales firm is much more efficient than TV station, or – If compensation scheme is changed (to increasing) 3 Specialization • Specialization on individual and firm level • Advantages – – – – Scale effects Learning effects Less change-over costs Comparative advantage • Disadvantages – Causes motivation (incentives) and coordination problems – Dependency fears may lead to duplication and underinvestment Comparative Advantage: Example • To produce a line of code, it needs to be programmed and debugged • Productivity (lines per day) Program Debug Anna 3 2 Barry 2 1 • Optimal solution: – Specialize: Anna debugs and Barry programs – This gives 2 lines per day (vs. 1.87 if they work on their own) 4 Comparative Advantage • Key Insight : Relative productivity (lines programmed / line debugged) : 1.5 for A vs. 2 for B => B should do the programming and A the debugging • Principle of Comparative Advantage : 1. What matters in allocation of tasks is comparative advantage, not absolute advantage. 2. Whenever there are differences in relative productivity, there are gains from specialization and trade. • Note: CA is also important in international trade 5 The Principal-Agent Problem • Arises when one person or organization hires another person or organization to act on its behalf (e.g. employment) • Principal is party doing the hiring • Agent is the person hired to act on behalf of the principal What’s the Problem? • Agent may have different objectives than the principal. Contracts and monitoring are imperfect. • Examples: – Sales Agents – Managers and shareholders – HMO’s and doctors – Administrators, faculty, TAs – Others 6 Solutions • Monitoring – Requires carrot & stick: efficiency wage, bonuses, employee’s reputation – More effective in repeated relationship • Incentive schemes (i.e. method of compensation) – Pay for performance • Commissions, piece rates • Lawyers: fixed fee, hourly rate, or contingency • Doctors: fee for service – Promotion tournaments • Intrinsic motivation via selection and socialization • Integration (for firms) ... but same issues remain 7 Pay for Performance • Output per worker typically goes up • Sorting: most productive workers stay – Also causes productivity to go up. – Average wage may increase. – Note : sorting is a leading source of misinterpreted analyses. • Productivity goes up after pay for performance is introduced : money makes people work harder? • Do MBA's earn more than others in professional firms? Issues with Pay for Performance • Difficult to get correct incentives – 'Outsourcing sales' issue applies broadly : α MR = MC instead of MR = MC • You get what you pay for – – – – – Caesarean sections Evaluating teachers by test performance Stock options for executives Typist at Lincoln Electric Multi-tasking problems • Agent bears part of risk and requires risk premium 8 Promotion Tournaments • Have employees compete on output & promote the winner • Implications – Flattening of hierarchy increases wage differential – Up-or-out policy (and tenure) • Issues – Competence for next level – Sabotage 9 Backloaded wages and rewards • To prevent employees from shirking, make it very costly to get fired. • Efficiency wages (i.e. paying more than market wage) are costly. • Solution: pay part of the wage at the end of career – Pensions – Backloaded wages (underpay when young, overpay when old) in form of increasing wage profile – Note: increasing wage profile might also reflect increase in skills Moral Hazard • Principal-Agent problem is part of larger problem: unobservability of actions or hidden behavior. • Imperfect information can encourage people to behave in "incorrect" ways. • Moral Hazard in Insurance Markets – Car Insurance - would you drive differently if you didn't have insurance? – Health Insurance - would you behave differently if you didn't have health insurance? 10 Moral Hazard: The RAND Health Insurance Experiment Copayment Rate 95% 50 25 0% (free) Expenditures on Medical Care 100% 142 300 417 Take Away Points • Comparative Advantage is an important reason for specialization and trade. • The Principal Agent problem is fundamental to understanding many aspects of employment relationship. • Potential solutions include monitoring, pay for performance, and promotion tournaments. • With any incentive plan, it is important to take the other's perspective, to understand their real incentives. 11