Chapter 21:
Getting Employees to Work
in the Firm’s Best Interest
Managerial Economics: A Problem Solving Appraoch (2nd Edition)
Luke M. Froeb, luke.froeb@owen.vanderbilt.edu
Brian T. McCann, brian.mccann@owen.vanderbilt.edu
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Slides prepared by Lily Alberts for Professor Froeb
Summary of 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 adverse selection (“which agent
do I hire?”) and moral hazard (“how do I motivate
agents?”) 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 with a risk premium), or
• sharing contracts and some monitoring (some shirking and
some risk sharing which leads to lower risk premium).
Summary of main points (cont.)
• 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 specific knowledge
(information) to the decision makers.
Summary of main points (cont.)
• 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 (performance
evaluation + reward system) to make good decisions?
• Alternatives for controlling principal–agent conflicts
center on one of the following:
• Reassigning decision rights (to someone with better
incentives or information)
• Transferring information
• Changing incentives (performance eval. + reward system)
Introductory anecdote: ASI
• Auction Service International (ASI) employed art experts to
convince owners of valuable art to use auction services to
sell their artwork.
• The auction house profited by charging the art owners a
percentage of the sell price at auction.
• This percentage was negotiated by the young art experts.
• A problem arose, the negotiated prices (“commissions” to
the auction house), which were supposed to be between
10 and 30%, were consistently low, near 10%.
• The CEO of ASI began investigating this phenomenon and
found that the art experts were “trading” low prices for
kickbacks from the art owner.
• Discussion: What are two possible solutions for this
problem?
Principal-Agent Relationships
• When studying firm-employee relationships we use
principal-agent models.
• Definition: A principal wants an agent to act on her
behalf. But agents often have different goals and
preferences than do principals.
• The auction house is a principal; the art expert is an
agent.
• Note: for convenience only, we adopt the linguistic
convention of referring to principals as female and
agents as male.
Incentive Conflict
• Because the agent has different incentives than the
principal, the principal must manage the incentive
conflict, which comes down to two problems with which
you should by now be familiar:
• Adverse selection: the principal has to decide which agent to
hire
• Moral hazard: once hired, the principal must find a way to
motivate the agent.
• Both problems are caused by asymmetric information: adverse
selection implies that only the agent knows his “type”; while
moral hazard means that only the agent knows how much
effort he is exerting.
• The costs of addressing moral hazard and adverse selection
are known as agency costs, because they are often
analyzed by principal-agent models.
Agency Costs
• A principal can reduce agency costs if she gathers
information (reduces information asymmetry)
• about the agent’s type (adverse selection); or
• about the agent’s actions (moral hazard).
• Information gathering:
• To mitigate adverse selection problems, firms can run
background checks on agents before they are hired.
• To mitigate moral hazard problems, firms can monitor
an agent’s behavior while working.
• This difference in timing leads to the characterization
that adverse selection is a pre-contractual problem,
while moral hazard is a post-contractual problem.
Incentive Pay vs. Risk
• Incentive pay can help align the incentives of employees
(agents) with the goals of the organization (principal).
• For example, if harder work leads to higher sales, then
create incentives by tying the employee’s reward to sales
performance, e.g., with a sales commission.
• But incentive pay also imposes risk on agents.
• Commissions mean a portion of an agent’s compensation is
dependent on factors beyond the agent’s control, e.g.,
weather.
• Agents must be compensated for taking on this additional
risk.
• So, incentive compensation represents a tradeoff:
• Does the benefit (harder work by agent) outweigh the cost
(extra compensation for bearing risk)?
Controlling incentive conflict
• In an ideal organization
• Decision-makers have all the information necessary to make
profitable decisions; and
• The incentive to do so.
• When designing an organization, you should consider
how to structure the following three items.
• Decision rights: who should make the decisions?
• Information: is the decision-maker provided with enough
information to make a good decision?
• Incentives: does the decision-maker have the incentive to
do so. Incentives are created by linking performance
evaluation and reward systems (rewarding good
performance).
Decision Rights and Information
• Who should make decisions?
• Decentralize decision making: move decision rights
down in the hierarchy, closer to those with better
information; or
• Centralize decision making: move decision rights up in
the hierarchy, closer to those with better incentives.
• If you decentralize decision-making authority, you
should also strengthen incentive-compensation
schemes.
• If you centralize decision-making, find a way to
transfer information to those making decisions.
Incentives (performance + reward)
• Performance evaluation
• Informal: using subjective performance evaluation, or
• Formal: using objective measures such as sales or
accounting profit, stock price, relative performance
metrics.
• Rewards: Decide how compensation is tied to
performance evaluation.
• Reward good performance and/or penalize bad
performance.
• Examples: bonus, increased probability of promotion,
faster promotion.
Example: Marketing vs. Sales
• Sales and marketing divisions often have incentive conflict
• Sales wants to maximize revenue, i.e., make all sales where
MR > 0
• Marketing wants to maximize profit, i.e., make all sales where
MR > MC.
• In other words, sales prefers a higher level of sales and a lower
price than does marketing.
• For example, a large telecommunications equipment
company that serves government agencies that buys telecom
equipment.
• Sales people want to bid more aggressively to make sure that
they win the contract (they care about maximizing sales)
• Marketing wants the sales agents to bid less aggressively, so that
when they do win, the contracts are more profitable (they care
about maximizing profit).
Marketing vs. Sales (cont.)
• Two solutions:
• Centralize bidding decisions to marketing; and try to
transfer enough information to marketing managers so
they know how aggressively to bid.
• Decentralize bidding decisions (keep decision rights with
the sales people) and change incentives – Instead of a 10%
commission on revenue, give sales people a 20%
commission on profit, (revenue neutral if the contribution
margin is 50%)
• Discussion: How well do threshold compensation
schemes work, e.g., a bonus if you open hit a target
sales number.
• Discussion: How well do high-powered sales
commissions work, e.g., 5% commission for sales of
$1M; 10% commission on sales of $2M, work?
Example: Franchising
• Incentive conflict exists between franchisors (McDonalds)
and its franchisees. McDonalds wants big franchise fees
and high quality at franchisees to protect its reputation.
Franchisees want smaller fees and lower quality
(cheaper).
• McDonalds has both company owned stores and
franchisees.
• In a company-owned store, both adverse selection and
moral hazard are concerns – managers don’t work as hard as
they would if they owned the restaurant, and a salaried
manager position might attract lazy workers.
• Franchisees have bigger incentive to work hard (because
they are the “residual claimants” of profit), but they are
also exposed to more risk. Franchisees have to be
compensated (lower franchise fees) for bearing risk.
Franchising (cont.)
• Another option is to use a sharing contract:
instead of a fixed franchise fee, the franchisor
might demand a percentage of the revenue or
profit of the restaurant.
• This arrangement reduces franchisee risk by reducing
the amount the franchisee pays to the franchisor
when the store does poorly.
• Sharing contracts may also encourage shirking
because the franchisee no longer keeps every dollar
he earns.
• DISCUSSION: Why does McDonalds use companyowned stores along freeways, but franchises in
towns?
Diagnosing and solving problems
• To analyze principal-agent problems, begin with the bad
decision that is causing the problem, and then ask three
questions.
1. Who is making the (bad) decision?
2. Did agent have enough information to make a good
decision?
3. Did agent have the incentive to do so, i.e., how is the
employee evaluated and compensated?
• Answers to these questions generally suggest alternatives
for reducing agency costs. You can,
•
•
•
Let someone else make the decision, or
Change the information flow, or
Change the incentives.
Example: Declining Store Profits
• The CEO of a large retail chain of “general stores” that
target low-income customers has noticed that newly
opened stores are not meeting sales projections.
• What is the problem here? And how can it be fixed?
• Some helpful information about the stores is,
• The company uses development agents to find new store
locations and negotiate the leases with property owners –
the company rewards these agents with generous bonuses
(stock options) if they open fifty new stores in a single year.
• Agents are supposed to open new stores only if their sales
potential is at least one million dollars per year, but
recently opened stores earn half this much.
• What is the problem; and what is the solution?
Alternate Intro Anecdote
• 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.
• Agent’s performance difficult for investors to observe or
evaluate
• Actions of crew on multi-year voyages 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
• Ownership rights were allocated to create powerful incentives
for their managers
• Agents usually held substantial ownership shares in their
ventures
Alternate Intro Anecdote (cont.)
• 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
• 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.
21
1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3.Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7.Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19.The problem of adverse selection
20.The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?