Incentives and Agency
Besanko, Dranove, Shanley, and
Schaefer
Chapters 14 and 15
1
Agenda
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Discussion of Agency Theory
The Agency Relationship
The Agency Contract
Modeling Performance Measures
Types of Contracts
Risk and Contracting
Firm Incentives
2
Agency Theory
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Agency theory is the study of incentives
to motivate workers.
Agency theory examines the
relationship between an agent and a
principal.
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An principal is a person/entity that
delegates responsibility to another, known
as the agent.
The agent acts on behalf of the principal.
3
Things to Consider in the Agency
Relationship
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What is an Agency Relationship?
Problems in Agency Relationships
Performance-Based Contracts and Risk
Aversion
The “Second-Best” Contract
Limited Liability
Sorting
4
What is the Agency
Relationship?
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Anytime that an agent acts on behalf of
a principal, there is an agency
relationship.
In an agency relationship there usually
needs to be some sort of implicit or
explicit contract.
5
Problems in Agency Relationships
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The principal and the agent tend to
have different objectives (agency
problems/agency conflicts).
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The principal’s objective is to maximize the
value of the agents productivity minus the
cost he must pay the agent.
The agent maximizes the amount he gets
paid for his work minus any incurred costs.
6
Contracting as a Method for
Providing Incentives
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The differing objectives of the principal and
the agent implies that there is a need for an
alignment of their objectives.
This alignment can occur through some form
of contracting.
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Contracting is made difficult due to hidden actions
and hidden information.
Contracting should focus on performance
measures which are visible.
7
The Agency Contract
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The agency contract spells out the
terms of the agency relationship.
The contract outlines the compensation
to be made by the principal to the
agent, given that a set of conditions are
met.
8
Modeling Performance Measures
in Incentive Contracts
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Suppose a firm hires an employee who exerts
an effort level of e.
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The firm pays this employee $1000 in base salary
which is the standard market rate.
For each unit of effort put in by the
employee, the firm’s sales increase by $10.
Assume that the cost of effort is zero if the
employee works 40 hours or less.
Also assume that the employee is willing to
work above 40 hours if he is compensated
0.5*(e-40)2.
9
Modeling Performance Measures
in Incentive Contracts Cont.
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What level of effort will the employee provide
if he only received the base salary?
What would happen if the firm paid the
employee a 10% commission?
What would happen if the firm paid the
employee a 20% commission?
What is the lowest level the firm could drop
the base salary and still get the employee to
work for it at the 10% and 20% rate?
10
Two Minimum Conditions of an
Agency Contract
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The agent must be willing to accept the
contract.
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This implies that the compensation to the agent
must be equal to or greater than her opportunity
cost, usually known as the threshold wage, of
doing something else.
The agent must be willing to comply with the
contract; hopefully within an efficient manner.
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This implies that the contract should satisfy an
incentive compatibility constraint.
11
Incentive Compatibility
Constraint (ICC)
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The ICC spells out the incentives that
will cause the agent to take efficient
actions.
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When the agent does not take the efficient
action, he is said to be shirking.
12
The First-Best Efficient
Contract
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The first-best contract causes the agent
to take efficient actions by satisfying
the incentive compatibility constraint
and gives the agent his threshold wage.
While many of these contracts may
exist, the principal prefers the contract
that pays the smallest compensation
necessary.
13
Three factors that Contribute
to Efficiency
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There is no hidden information held by
the agent.
Principals have full information about
actions.
If the agent performs the contract, the
agent is at little or no risk of not getting
compensated.
14
Other Problems in Agency
Relationships
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Two major issues are at the heart of the
problems in agency relationships:
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Moral Hazard—This occurs when there are
opportunities to shirk because of
incomplete contracting.
Imperfect Observability—This occurs when
the principal cannot observe perfectly the
agents actions.
15
Moral Hazard
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Moral hazard tends to result from either
hidden actions or hidden information.
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Hidden actions occur when the principal
cannot perfectly observe the agents
actions.
Hidden information occurs when the agent
has information that the principal does not.
16
Observability
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Observability is one key way to prevent
shirking.
In some situations, observability is easy to
achieve, especially when there are outwardly
signs.
In other cases observability may be difficult
to directly achieve.
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In this case, the principal may use an observable
proxy action that is highly correlated with the
unobservable action.
17
Piece Rate Contracts
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A piece rate contract pays a fee for
each unit of output produced by the
agent.
These contracts are easy to implement
when the principal can easily observe
the agent.
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With piece rate contracts, the principal
needs to take into consideration the quality
of the output.
18
Piece Rate Contracts Cont.
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Problems with piece rate
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These contracts do not generally give the
efficient effort.
These contracts may induce too much
production.
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Cost-Based Contracts
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A cost-based contract is where the
principal compensates the agent for all
reasonably incurred costs plus a
specified level of profit.
These contracts do not provide a
mechanism to stop shirking.
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Performance-Based Contracts
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A performance-based contract is a
contract that makes compensation
contingent on the agent meeting some
pre-established performance objectives.
Performance-based contracts must take
into consideration the level of risk an
agent is willing to take.
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Three Factors that Make for a Good
Measure of an Employee’s Performance
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One that is less affected by random
factors
One that reflects all the activities the
firm wants to encourage
One that does not encourage
counterproductive activities
22
Willingness to Bear Risk
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There are three general classifications of a
persons risk preferences:
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A risk averse agent is one that would prefer a
guaranteed payoff over a payoff under uncertain
conditions that have the same expected payoff.
A risk neutral agent is indifferent as to whether to
take a guaranteed payoff or a gamble that has the
same expected payoff.
A risk loving agent would prefer to take a gamble
over a guaranteed sum of money as long as the
expected return from the gamble is the same as
the guaranteed sum.
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Risk Premium
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A risk premium is a compensation
required to induce the agent to take on
some risk.
When agents are risk averse, a risk
premium is necessary to induce them to
take on some risk.
24
The “Second-Best” Contract
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This contract maximizes the principal’s
expected profit subject to the following
constraints:
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The agent’s utility is at least as high if she
pursued her next best alternative.
The contract induces the agent to provide
the principal’s desired level of effort.
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Simple Way of Representing
the Second-Best
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W = A + BX
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W is the agent’s compensation
A is the agent’s fixed component of her
compensation
B represents the extent to which
compensation is tied to performance
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When B is large, it is known as a higher-power
performance incentive
X is a measure of performance
26
Compensation for
Performance (B)
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The optimal value of B is a function of
the following:
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The agent’s risk aversion
The agent’s effort aversion
The marginal contribution of effort to
profitability
The noisiness of the performance measure
27
Limited Liability
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When an agent is unable to pay
penalties for poor performance, the
agent is said to have limited liability.
When an agent has limited liability, the
principal may have to pay an efficiency
wage.
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The efficiency wage is the amount of
compensation that induces the agent to
take the efficient action.
28
Sorting
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When there are multiple potential
agents, then a contract may need to be
written in such a way to systematically
influence the characteristics of the
agents.
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This is known as sorting.
Sorting relates to structuring the incentives
in the contract to obtain the workers that
will optimize the principal’s payoff.
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Rules of Thumb for Sorting
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More able and/or risk taking agents
prefer pay-for-performance contracts.
Low mobility workers prefer schemes
that link pay to job tenure.
Agents with limited liability are more
willing to accept contracts that provide
larger rewards for success and large
penalties for failure.
30
Complications to the Agency
Relationship
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Multiple Agents and Teams
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Since monitoring team performance can be
difficult, structuring contracts for the
agents can be difficult.
Multidimensional Agency
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If an agent is doing unrelated tasks, then a
contract needs to take into consideration
how to structure the incentives so one task
is not unduly put before another task.
31
Subjective Performance
Evaluations as Incentives
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When dealing with incentive contracts,
there tends to be a subjective
evaluation of performance.
These evaluations can come in the form
of:
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360-degree reviews
Management by objective systems
Merit rating systems
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360-Degree Reviews
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This form of evaluation requires an
employees supervisor, coworkers, and
subordinates to evaluate him over a
period of time.
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Management By Objective
Systems
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This form of evaluation requires the
employee and the supervisor to sit
down and develop a set of goals for the
employee.
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At the end of a certain time period, the
supervisor meets with the employee to
evaluate the accomplishment of the goals
and the environment in which they were
achieved.
34
Merit Rating Systems
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In these systems, a supervisor allocates a
score to the employee for the work that he
accomplished.
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In many cases the supervisor is allocated a certain
amount of points to allocate to all the employees,
which requires the supervisor to give higher points
to better employees.
These systems often suffer from ratings
compression.
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Problems with Subjective
Performance Evaluations
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Supervisor need proper incentives for
them to provide good evaluations.
Subjective evaluations can lead to
employees wasting resources on
influence activities.
36
Promotion Tournaments as
Incentives
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A promotion tournament is where a firm
provides an opening at a higher level
within the firm that provides higher
compensation and requires employees
to compete for the position.
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Advantages to Promotion
Tournaments
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It deals with supervisors who are
unwilling to make distinction between
employees.
They are a form of relative job
performance evaluation, i.e., they
compare one employee to another.
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Disadvantages of Promotion
Tournaments
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They may not take into consideration
who has the greatest potential in the
higher level position.
They can cause employees to not work
with each other.
39
Efficiency Wages and Threat of
Termination as Incentives
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An efficiency wage is defined as a wage that
is high enough to induce a desired level of
efforts.
Some firms use efficiency wages and a threat
of termination to motivate employees to put
forth their best efforts.
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Higher wages with the threat of termination can
cause employees to work harder to keep their job
and can be used instead of monitoring.
40
Incentives for Teams
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Many projects that are undertaken by
employees require team interaction.
Since team-based performance
evaluations focus on the output of the
team, this implies that the benefits from
a particular individual’s actions are
shared with the entire team.
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This potentially causes a free-rider
problem.
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Methods to Alleviate the FreeRider Problem in Teams
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Keep teams small.
Put team members on multiple projects
over time so they can have the
opportunity to punish team members
who are shirking.
Structure teams so each member can
monitor what the others are doing.
42