Enterprise Compensation Incentive Theory on Principle-agent Relation
Huo-bao Xie 1, Chun-yan Chen2
1
Economic and Management School, University of Whuhan, Whuhan, China
Economic and Management School, University of Whuhan, Whuhan, China
(lwpwanger@163.com)
2
Abstract - This paper makes an analysis of the
enterprise compensation incentive theories and documents
their own advantages and shortcomings. From the
perspective of principle-agent relationship, it put forward
the opinion that tournament theory and behavior theory are
suitable used in the relation between shareholders and
managers, while piece-rate theory and time –rate theory are
mainly applied in relation between managers and the
front-line workers
Keywords -Compensation, incentive theory, Principleagent relation
Ⅰ. INTRODUCTION
Principle-agent relation is a contract under which
one or more persons (the principal(s)) engage another
person (the agent) to perform some services on their
behalf which involves delegating some decision-making
authority to the agent (Jensen and Meckling, 1976)[1]. In
real life, it is necessary to point out the generality of the
principle-agent relation, which exists in all organizations
and in all cooperative efforts—at every level of
management in firms (Jensen and Meckling, 1976)[1].
With the ‘separation of ownership and control’ of the
corporation, shareholders and managers form pure
principle-agent relationship. While managers further
decompose the goals and tasks of the organization and
deliver them to the front-line workers to accomplish with
the organization. Therefore, the managers and the
front-line workers form the implicit principle-agent
relationship. Both parties of the principle-agent
relationship as ‘rational economic man’ seek their own
utility maximization. The agent will not always act in the
best interest of the principal. In the place out of the
supervision of the principal, he may shirk or even seek
his own benefit maximization by using his private
information even in spite of damaging the interest of the
principal. The principal can limit the agent’s aberrant
activities which damages his own interest by making the
necessary monitoring and establishing appropriate
incentives for the agent. As the analysis shows, as long as
in some cases, employees have more specific information
about the environment then managers, the employee’s
_______________________
Thank for the support of national social science fund project
“State-owned Enterprises Executive Compensation Management
System Reform in China” (10BGL067)
.
incentive problem is still in need of being solved 1. At
present, the academic research on motivating and
inducing the agent serves the principal’s welfare
maximization, gradually developed a series of
compensation incentive theories— tournament theory,
behavior theory, piece-rate theory and time- rate theory.
Ⅱ. COMPENSATION INCENTIVE THEORY AND
LITERATION REVIEW
Lazear & Rosen (1981)[2] put forward tournament theory,
which deeply interprets the agent relation between
shareholders and managers of companies by using game
theory and designing wage spread. Tournament theory
states that if monitoring is difficult and the costs of
monitor are very expensive, then managers will reduce
their input with less than perfect detection. Shirking has
become a serious problem. The situation can be improved
under condition of that compensation is related with the
agent’s outputs which can be measured in an easy way.
Therefore, it is optimal to set up compensation incentive
mechanism according to an individual’s ordinal rank in an
organization rather than his absolute out-put level. For
these reasons, the rank-order payment scheme is
sometimes a superior way to bring about an efficient
incentive structure. Eriksson (1996) [3] tests several of
tournament models by collecting a data of 2600
executives in 210 Danish firm from1992 to 1995. The
result indicates that firm performance has a positive and
significant correlation with wage spread, which is in
consistent with tournament theory. Junqing, Zuhui and
Yongxiang (2003)[4], Yixuan (2010)[5], Yongle and
Jizhong (2010)[6] have made some empirical analysis from
the relation between performance and wage spread. Their
findings also support tournament theory.
Behavior theory is a branch about fair distributive of
rewards, mainly involving equity theory, relative
deprivation theory and distributive justice theory. Equity
theory thinks that people in social exchange relationships
believe that rewards should be distributed according to the
level
of
individual
contribution
(Adams,1965;
Homans,1974)[7][8]. Individuals always compare the ratio
of inputs to outcomes with that of reference groups they
have chosen to judge whether they are treated fairly by the
organization. If the ratio is dissimilar, then individuals
will perceive unfairness, so that they may alter their actual
1
The Economic Nature of the Firm, second edition edited by Louis
Putterman and Randall S.Kroszner, this simplified Chinese translation
edition jointly published by Cambridge University press and Shanghai
university of Finance and Economics press 2009.
inputs by decreasing their work effort and even possibly
terminate the inequitable relationship by leaving their
organizations (cowherd & Levine, 1992) [9]. Relative
deprivation theory states that individuals will suffer the
deprivation when they compare the rewards they receive
to that of reference groups and find that they have
received less than what they deserve (Martin, 1981;
Crosby,1984)[10][11]. Relative deprivation theory typically
deals with the upward comparisons made by low-status
people. Once the low-status people perceive the
deprivation, they will have the obvious directed behaviors
with destructiveness, including absenteeism, strikes,
vandalism, and violence. Distributive justice theory states
that a certain level of pay gap is reasonable between the
low-status workers and the high-status managers because
of the difference of their interclass inputs (cowherd &
Levine, 1992)[9]. However, the influence of the difference
of the interclass inputs on pay equity perceptions is
limited for the reason that inputs are typically more
ambiguous relative to compensation, and are subject with
strong self-enhancing perceptual biases (Cook and
Yamagishi, 1983) [12]. So the perception of the low-status
employees of whether they are treated fairly
will
mainly depend on the fair compensation distribution
between the lower and higher organizational strata (Jasso
and rossi, 1977) [13]. Therefore, once the low-status
employees suffer the unfairness of rewards, they will
reduce the degree of commitment to their organization and
lower the level of cooperation among their workmates.
Zhengtang and Xin (2007) [14] use the data of 264 Chinese
listed companies from 2001 to 2004 make an empirical
analysis about this question. The result indicates that firm
performance has a negative and significant correlation
with the wage spread, which is consistent with behavior
theory. Zhengtang (2008) [15] also finds the same
conclusion.
Piece rates are defined as that works are paid
according to their outputs and given a fair price for each
unit completed work. Piece-rate theory provides workers
with incentives to work harder and faster to get higher
rewards for their higher productivity. However, piece
rates have two serious shortcomings. The first is that
managers can’t make certain workers’ productivity
because workers have the private information about the
difficulty of their jobs. The second is that employers
always cut the price paid to workers in practice so that
employers have the opportunity to revise the rate over
time (Gibbons, 1987) [16]. Time-rate theory is a
compensation payment scheme that workers are paid
according to the time they have spent on their work rather
than their outputs in a short time. Although, in a long run,
the corporations still make decisions of keeping job
position or promotions according to the performance of
the workers2. In a situation of complete information, the
principals know all activities done by the agents, under
which time-rate theory is the best incentive compensation
scheme. While, in a situation of incomplete information,
the incentive effect of time-rate is not desired. Lazear
(2000) [17] makes an analysis of the effect of monetary
incentive on outputs by collecting data from Safelite
Glass Corporation during 1994 and 1995. The results
imply that the shift of the compensation method from
hourly wages to piece rates bring about an increase 20%
in productivity, 10% in income received by workers .
2
3
Labor Economics third edition, edited by George J. Borjas, this
simplified Chinese translation edition jointly published by McGraw-Hill
Education (Asia) Co. and China Renmin University press 2010
Ⅲ. ANALAYSIS AND APPLICATION OF
COMENSATIN INCENTIVE THEORY
For the principle-agent relation between shareholders
and managers, tournament theory and behavior theory are
mainly used due to shareholders’ expensive monitoring
cost and managers’ marginal outputs which are not easy to
be measured. Generally speaking, tournament theory
induces managers to work hard by a large amount prize
from the perspective of individual competition. Behavior
theory encourages the cooperation among managers to
improve the organizational performance from the
perspective of equity. Tournament theory emphasizes
competition, while behavior theory emphasizes
cooperation. Hence, it is appropriate to apply tournament
theory for managers in charge of production, sales and
projects whose outputs are easy to be measured in a
relative performance rank order. Instead, it is good for
applying behavior theory for managers in charge of
administration and logistics management whose outputs
are not easy to rank order.
For the principle-agent relation between managers
and the front-line workers, piece-rate theory and time -rate
theory are mainly applied in practice. Which theory do the
corporations choose to induce the front-line workers to
work harder depends on industry, department, monitoring
cost and incentive effect. From the perspective of
industry, piece-rate theory and time rates are always used
in manufacture. In the industries of candy, industrial
chemicals and assembly structure steel, more than 90%
workers are paid by time rates. While in the production
industries of shoes, shirts as well as steel and iron
materials, more than 75% workers get rewards according
to piece rates 3 . From the angle of departments in
corporations, the production and sale department where
the front-line workers’ outputs are easy to be measured
generally applies piece rates. While the human resource
management department and logistics department, where
the outputs of the front-line workers’ outputs are uneasy to
be measured, generally applies time rates. From the view
of monitoring costs, the front-line workers’ wage level
should equal to their marginal product value under piece
rates, so it is necessary to know worker’s real
Labor Economics third edition, edited by George J. Borjas, this
simplified Chinese translation edition jointly published by McGraw-Hill
Education (Asia) Co. and China Renmin University press 2010
productivity. However, one of the piece-rate’s
shortcomings is that managers can’t make certain
workers’ productivity because of workers’ private
information about the difficulty of their jobs. As a result,
managers have to monitor their employees’ work all the
time, which causes expensive monitoring cost. Under time
rates, the fixed wages are paid to workers according to the
time spent on jobs rather than their outputs. It is not
necessary to monitor workers’ work from the beginning to
the end, which saves the monitoring cost. Therefore, the
enterprises with expensive monitoring costs choose time
rates, while those with inexpensive monitoring costs
choose piece rates. Finally, workers with higher ability
can obtain higher utility under piece rates, but they can’t
obtain higher utility under time rates. Under piece rates,
workers with high ability make more products, obtain
higher income and naturally achieve greater utility. On the
contrary, the utility of high ability and low ability workers
who are paid by time rates is the same due to that workers
are paid by the time spent on work, As long as workers
spent the same time on work despite of how much effort is
put into work, they all get the same wages and utility.
Thus, considering the incentive effects, pieces rates can
attract workers with higher ability and induce them make
effort to work while time rates can’t achieve the same
effect.
Ⅳ. CONCLUSION
In a word, each compensation incentive theory has its
own advantages, shortcomings, application range and
conditions of application. For the principle-agent relation
between shareholders and managers, tournament theory
and behavior theory are mainly used. Specifically,
managers who are responsible for production, sales and
projects are appropriate to use tournament theory. Instead,
managers who are in charge of administration, human
resource and logistics management are suitable to use
behavior theory. For the principle-agent relation between
the managers and the front-line workers, piece-rate theory
and time rates are mainly applied in practice. To be
specific, it is appropriate to apply piece rates for the
enterprises with inexpensive monitoring costs, the
departments with outputs easy to be measured and the
workers with higher ability. On the contrary, it is better to
apply time rates for the enterprises with expensive
monitoring costs, the departments with outputs uneasy to
be measured and the workers with lower ability.
ACKNOWLEDGMENT
I appreciate my friends for their advices and help in
the process of my writing. Also, I am very thankful to my
families who give me the peaceful study environment and
the spirit encourage in spite of how many difficulties they
meet in their life. At the same time, I deeply thank for
Wuhan University for the rich academic research
materials and the good academic atmosphere. This article
has its limitation about the compensation incentive theory.
Although this paper gives some advantages and
shortcomings of various compensation incentive theories,
it is necessary to collect data to make an empirical
analysis to prove their applying conditions and ranges.
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