Chapter 21: How to get employees to work in the firm’s best interests
1. Introduction
This is Professor Luke Froeb and I, along with Brian McCann, am the author of
“Managerial Economics: A Problem Solving Approach.” This video is designed to
complement Chapter 21: “getting employees to work in the firm’s best interests”
Planes frequently push back from the gate on time, but then wait 2 feet away from
the gate until it is time to queue up for take-off. This increases fuel consumption,
and increases the time that passengers must sit in a cramped plane awaiting takeoff.
One look at the wage scale for flight crews tells you why this occurs:
The first row (per diem) indicates how much the flight crew earns once it checks
into the airport, the second (holding pay) after it loads the plane, and the third
(hourly wage) after it pushes back from the gate and turns on the beacon. By
rushing to load the plane, and push back from the gate, the captain earns $164/hour
more than he or she does by waiting to load the plane.
At this point, you should be able to diagnose and solve this problem using the
problem solving framework we introduced in Chapter 1. Simply ask the three
questions:
1. Who is making the bad defcision: Airline captains are pushing back from the
gate too early;
2. Do they have enough information to make a good decision; yes, in fact they
are the only ones with enough information to do so;
3. Do they have the incentive to
It would be relatively easy to solve this problem by taking the decision on
when to push back from the gate away from the flight crew and give it to the
airline instead.
21. GETTING EMPLOYEES TO WORK IN THE BEST INTERESTS
OF THE FIRM
Principal-Agent Relationships
Principles for Controlling Incentive Conflict
Marketing versus Sales
Franchising
A Framework for Diagnosing and Solving Problems
Main Points
•
Principals want agents to work for their (the principals’) best interests, but
agents typically have different goals than do principals. This is called
incentive conflict.
•
Incentive conflict leads to moral hazard and adverse selection problems
when agents have better information than principals.
•
Three approaches to controlling incentive conflict are
• Fixed payment and monitoring (shirking, adverse selection, and
monitoring costs),
• incentive pay and no monitoring (must compensate agents for bearing
risk), or
• sharing contracts and some monitoring (some shirking and some risk
compensation).
•
In a well-run organization, decision makers have (1) the information
necessary to make good decisions and (2) the incentive to do so.
•
If you decentralize decision-making authority, you should strengthen
incentive compensation schemes.
•
If you centralize decision-making authority, you should make sure to transfer
needed information to the decision makers.
•
To analyze principal–agent conflicts, focus on three questions:
• Who is making the (bad) decisions?
• Does the employee have enough information to make good decisions?
• Does the employee have the incentive to make good decisions?
•
Alternatives for controlling principal–agent conflicts center on one of the
following:
• Reassigning decision rights
• Transferring information
• Changing incentives
Supplementary Material
ManagerialEcon.com (Chapter 21)
James Brickley, Clifford Smith, Jerold Zimmerman, “The Economics of
Organizations,” Journal of Financial Economics, Vol. 8:2 (Summer, 1995) pp. 1931.
I not only want you to be able to identify profitable decisions using benefit-cost
analysis (the main thrust of the course as reflected in course goals), but I also want to
make sure that you can implement them within your organization. Identifying
profitable decisions without being able to implement them, or implementing
decisions without knowing whether they are profitable, are both fruitless exercises.
This article provides the basis for our study of behavior within organizations. The
authors present a methodology for diagnosing and repairing problems within an
organization. To implement it, you need to ask three questions:
i.
ii.
iii.
Who is making the decision?;
How are they evaluated?; and
How are they compensated?
Answers to these questions will suggest solutions to the problem centered on:
i.
ii.
iii.
Re-assigning decision rights;
Changing evaluation schemes; and/or
Changing compensation schemes.
We will use this methodology throughout the course to analyze why business
mistakes are made, so it is important to read this article right away and begin
using it to diagnose and correct mistakes.
Teaching Note
The main point of class time is to
1. Explain the link between the problems of moral hazard (how to motivate
employees) and adverse selection (whom to hire), and the principal-agent
problem.
2. Teach the tradeoffs inherent in various solutions to principal-agent problems
(risk vs. incentive pay)
3. Get students to understand how the problem-solving framework introduced
in the opening chapter is based on principal-agent analysis (who is making
the bad decision; do they have enough information to make a good decision;
and the incentive to do so)
The slides explain the theory using the auction house story to illustrate the theory,
and they follow the book fairly closely. I find that it helps to bring up other
principal-agent problems and ask students how to align the incentives of the agent
with the goals of the principal. Then ask questions about which of various solutions
reduces agency costs.
I sometimes bring up the classic landowner-tenant farmer principal-agent problem.
Weather is the source of risk, and the landowner cannot observe how much effort
the farmer is putting out. Tell them that the problem is the low output of the farm,
and ask them how to solve the problem. Students often find this anachronistic, so in
the text, I use the more complicated McDonald’s franchisee and the parent company
(more sources of incentive conflict about maintaining the quality of the brand). Ask
them what the principal agent incentive conflict is and how to solve it.
An alternate route to take is to assume that students have read the chapter, and then
present a series of principal agent problems and ask them to: 1. figure out what’s
wrong and 2. how to fix it. Play 20 questions (make them ask you yes or no
questions until they figure out what the problem is; and then ask how to fix it.) Be
sure to ask them questions about proposed solutions that illustrate the principalagent tradeoff. Remind them that there are costs and benefits to any solution.
The stories in the last chapter, “You be the consultant” can be used for this as it is
not a chapter that requires a lecture to go with it.
In-class Problems
QUESTION: One fun question to use is the story from the old Alchian-Allen
textbook: “in the early 20th century, a woman takes a ride on a boat and is shocked
to see the oarsmen being whipped by an overseer.” What is the principal-agent
problem the whipping is supposed to solve? Play twenty questions and make
students guess the answer.
ANSWER: The oarsmen collectively own the boat and hire the overseer to whip
them in order to solve the free riding problem.
QUESTION: A company-owned McDonald’s located on the NJ turnpike has low
output, much less than a franchisee owned store in the nearest town. Why?
HINT: Step back and ask students why the company owns stores on the freeway
and franchisees own stores in town.
ANSWER: Repeat customers give franchisees incentive to keep quality high in town.
On freeways (where repeat business is lower), franchisee can shirk on quality.
QUESTION: What is the principal agent conflict between shareholders and
managers and how does it get solved?
ANSWER: Examples of potential solutions include incentive pay with stock options;
monitoring by outside directors; concentrated stock ownership.
Additional Anecdote: Whaling Industry
Discuss the following article
Incentives in Corporations: Evidence from the American Whaling Industry
Eric Hilt
NBER Working Paper No. 10403
March 2004
JEL No. N5, L2, G3
Whaling ventures in the 1800s were managed by agents, who would purchase
supplies, hire a captain and crew, and plan the voyage on behalf of the investors.
The agent’s performance, however, was difficult for investors to observe or
evaluate. The actions of crew members on multi-year voyages were even more
difficult to evaluate.
Contracts and organizational forms century evolved in response to these problems.
Most whaling enterprises were closely held by a small number of local investors,
and ownership rights were allocated to create powerful incentives for their
managers. Agents usually held substantial ownership shares in their ventures
Attempting to run these ventures via corporation form in the 1830s and 1840s
failed. They paid their crews the same ways, used similar vessels, and employed
agents with similar responsibilities. The only main difference was in ownership
structures and hierarchical governance. They were unable to create the incentives
requisite for success in the industry. The managers of these corporations, who did
not hold significant ownership stakes, did not perform as well as their peers in
unincorporated ventures.