Chapter 12: Teams and reward
systems
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Why do firms exist in the first place?
When should teams be used?
How does peer pressure operate in a team?
How should a team look like, which
individuals should form a team?
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Team compensation
When/why would a company use team
compensation?
• Individual effort difficult to measure
• Motivate cooperation among workers
• Congruence of type of work and type of
compensation:
If teamwork is important, use team-related pay
Ex: Basketball
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The free-rider problem
• When individuals work in teams, it is
difficult to observe the output of individuals
 possibility: compensation by team
• But: individuals can hide behind others
(free ride)
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Public goods problem
Everybody in team contributes to output,
but each member gets only a share of the
reward for own action
– Example: sharing the bill at a restaurant
• Ten people go to the restaurant and share the bill.
Do you order the cheap (6 €) or expensive menue
(12 €)? Why? What is the result?
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Everyday economics
Lesson for staying slim?
• Go out in small groups and
• Never share the bill!
• Problem is: why are the French and
Italian so slim?
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Public goods problem
• There are two individuals i and j with 10 € each.
The money can be invested into a public good (x)
or be kept for oneself.
The payoff of individual i is given by:
(10 – xi) + 0.6 (xi + xj)
• How much would you put into the public good?
• Assume there is only the choice of putting all or
nothing into the public good. How does the
payoff-matrix look like? What is the result?
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Public goods problem
Ten people are one team. Group gets a
bonus of € 100 if project is finished one day
earlier. Bonus will be divided by number of
group members.
– If you worked overtime one evening - instead
of going out with your friends - you could
speed up the project enough, so that it would be
finished earlier. Will you stay late?
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Result of public goods problem
• One-shot prisoner‘s dilemma
– Efficient solution would be that everybody contributes
everything to the public good
– Nash-solution will be that nobody contributes anything
Remember from Managerial Economics or IO:
• In finitely repeated games: No cooperation
• Only infinite repetition of game or uncertainty about the end of
game leads to cooperation
• Else: non-economic reasons like trust, norms, etc... See later
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WHEN TO USE TEAMS
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When to use teams?
• Benefits:
– Output of two (or more) workers together is more than the sum of
the outputs of each worker  „Use teams if the whole is bigger
than sum of its parts“
– Large complementarities what one worker does and what another
does
• Deadlines to meet
• Physical complementarities (lifting an object)
• Share information and coordinate better
• Costs: productivity loss through free-riding
– affected by size of team
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When to use teams?
• Benefits: Output of two (or more) workers together is
more than the sum of the outputs of each worker
 „Use teams if the whole is bigger than sum of its parts“
Example:
2 projects, each can be done by one worker in 4 weeks
or two workers in 2 weeks.
– Project A gives profit of € 10.000 if finished in 2
weeks, else € 5.000.
– Project B has to be finished in 4 weeks, gives profit of
€ 15.000.
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Other direct benefits of team
work
• Specialization
– Allows to do job more efficiently (Adam Smith)
• Knowledge transfer (if specialization is not too great)
– 1. Individuals possess non-overlapping (idiosyncratic) information
sets
– 2. Idiosyncratic information possessed by one person is valuable to
others
–  team should consist of people who have something to share
• Ex: accountant and auto-mechanic
• Ex: research team: theory, econometrics and data access
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Information Frisch has
Information Engel has
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Team size
• Large teams create communication problems
• Small teams do not have enough info to share
• Incentive intensity determined by team size:
– own benefit = return to own effort/group size
– The larger the team, the more severe is the free-rider
problem
– Peer monitoring more effective in smaller teams
• Easier to observe effort in small teams („It wasn‘t me!“)
• One member‘s shirking has bigger effect on every other
worker, so incentive to punish her is bigger
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Incentives in teams
1.
2.
3.
4.
5.
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Team bonus
Profit sharing
Stocks and options
Implicit rewards
Norms
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1. Team bonus
Bonus for finished project, split among
members
– Small groups
– Well-defined project/output
– Short duration, so that team remains intact
• Ex: construction project
• Ex: football team
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2. Profit sharing
Reward based on company profits, typically split in
proportion to worker‘s base salary.
Share = (worker j‘s base annual salary)/total wage bill
• Team = whole firm
• Why would somebody set group size so high?
– Free-rider problem enormous!
– Workers have their human capital already tied up in one firm, they
should diversify their financial capital to reduce risk (ex. ENRON)
• Important argument against firm-specific pension fund
• Profit sharing is risk sharing which transfers some of the
risk from stockholder to workers (should be compensated)
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Profit sharing
in a more positive light
• Profit sharing can be motivating
– Symbolic action, can help to internalize firm goals „We
are one!“
– Intrinsic motivation more important if explicit
incentives are difficult to install
– Create a „firm spirit“ of high-commitment as incentive
mechanism
– Sometimes „firm spirit“ particularly valuable
(trademark, customer contacts, quality of product
important, etc.)
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3. Stocks and options
Usually for high-level managers
– Cooperation is very important
– Impact on firm is big
– Makes them care about own and other peoples‘
output
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Stocks and options
• Stock: ownership claim on a corporation
• Call option: the right to buy stock to the exercise
or strike price K in future.
– „In the money“: Market price (X) of stock exceeds
strike price (K)
– „Out of the money“: X < K: Option is not exercised
– Employee profits from the call option if it is „in the
money“, i.e. the strike price is lower than the market
price at pre-specified date.
• Stock of the firm is an option with strike price=0.
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Value of an option contract
• Assume an option has a 50 % chance to be worth € 90
or € 110 each.
• Current stock price is € 100
• Assume: you want to give the manager a reward with an
expected value of €100.
Strike price
Value of one option
Number of options required
0
100
1
80
20
5
100
5
20
108
1
100
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Value of an option contract
• The higher the exercise price, the larger the
number of options that must be granted to
produce a given expected value.
• Which combination of number/exercise price
should firm choose?
– Consider: value of an option increases as value of firm
rises.
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Value of an option contract
• Example: Action of worker (i. .e. high effort of the worker) increases
value of firm by € 1 mio. There are 1 million shares, so the action
raises value of every share by € 1.
Strike
price
Number of
options
required
Value of one option
(no action)
Value of one option
(after action)
Net value of
action to
manager
0
1
100
101
1
80
5
20
21
5
100
20
5
5.5
10
108
100
1
1.5
50
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Value of an option contract
• Incentive effects differ for options with
different strike prices:
– Large number of options with higher strike
price creates higher incentive for manager
• Leverage effect
• Managers have incentive to choose more risky
projects
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Why have options become
popular?
• Have been introduced in period of rising
stock prices
• Tax treatment in some countries
• Good incentive effects for managers
• Possibility of spreading the risk for the firm
(costs relatively little in case of success and
nothing in case of failure)
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4. Implicit rewards
• Firms usually pay higher wages when they
make higher profits (to all workers)
– Bargaining power of workers is higher
– Firm does not want to lose workers
• In most firms, these implicit bonuses
account for a bigger share of a firm‘s wage
bill than explicit bonuses.
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5. Can norms help to alleviate
group free-riding ?
• Norms are practices a firm engages in or a set of
beliefs held in a firm, part of a firm‘s culture
• Monitored by peer pressure: e.g. criticism, ostracism
(Ächtung)
– Peers bear ongoing enforcement costs for the norm, punish
violators with lower (sometimes also higher) effort levels
– Norms break down if pressure lets up and enforcement lags
– Workers have a hard time to empathize with nameless,
faceless shareholders, but more easily with co-workers
– Creating norms leads to empathy, loyalty and latent guilt
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Group composition
• People are different, differently suited for different tasks
• People possess different pieces of information
– Takes time to convey information, but maybe diminishing returns
of doing so
• Rotating of group members
• Con: „Person-specific“ HC, takes time to get to know each
other and build up trust and communicaton (e.g. people
from different disciplines!)
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