Remuneration & Monitoring

1. Remuneration & Monitoring • 1. Introduction • 2. Principal-Agent Theory • 3. Do incentives work? • 4. Empirical evidence

2. 1. Background • What is the role of the wage? • (i) Allocation function • ‘In a competitive economy, wages should act as guideposts informing people which occupation to take,…, or how long to stay in school, or when to change jobs…’ Polachek & Siebert, 1993 • (ii) Social stratification \ cohesion function • custom & practice, fair wages (Marshall, Hicks)

3. (iii) Management tool • Outcomes (I.e. output) depends on worker effort • Workers have free will • effort & specific skills • effort is a ‘bad’, higher wages are a ‘good’ • Firms wish to maximise effort / skill use • Divergence of interests • Informational asymmetries • Workers act opportunistically

4. 2. Theory Principal-agent problem Profit Shareholders Board of Directors Pay, growth CEO, managers Supervisors, workers

5. How does the principal ensure that the agent supplies maximum effort? • Designing the optimal contract • a) available information • b) distribution between managers & workers • c) attitudes to risk of principal & agent • 1. Perfect information • effort & other factors affecting output (Q) are observable & measurable • no agency problem • contract: Q = f(e); if Q is produced, worker paid W • no monitoring by principal

6. 2. Symmetric information • Assume • Q = Q(e, ) •  is a random (stochastic) variable •  reflects ‘state of nature’ • weather • breakdowns, supply problems • Macroeconomic conditions •  = unobservable • Q is therefore stochastic - output is uncertain - See Table 1 • Assume that  is known to worker/firm

7. Table 1 Output when e and  vary A) Uncertainty of outcome! B) If  is known, a contract specifies e1 if ave and e2 otherwise; C) What should W be?

8. Wages and attitudes to risk • Fixed wage - principal bears the risk • Variable wage - risk sharing • Should the risk be shared? • Depends on attitude to risk e.g. • risk averse managers • risk neutral shareholders • shareholders should bear all the risk. Why?

9. 3. Risk, uncertainty & asymmetric (imperfect) information • (i)  is unknown • (ii) the effect of e and  on Q cannot be determined • (iii) …but effort is known to the worker • Paying a wage conditional on e may not lead to Qmax • Why?

10. 3. Optimal contract - incentive to deliver e1 • Offer a contract to maximise expected • E{[(Q(e, ) - w(Q(e, ))]} • Subject to (a) workers optimal level of effort • E{u[e,w(Q(e, ))]} • i.e.’incentive compatibility constraint’ • nb if bad then e1 may still result in low wage i.e. risky • And (b) the ‘participation constraint’

11. The participation constraint • Utility associated with a contract  u* • E{u[e,w(Q(e, ))]}  u* • Thus • If workers are risk averse, what type of contract will maximise effort and hence Q? • i.e. output = 3,000 rather than 1,000

12. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f() YA Y=X Low output u1 u0 XA High output1

13. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f() YA Y=X Low output a u1 b u0 XA High output

14. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f(, e) YA Y=X Low output w0 u0 XA High output

15. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f(, e) YA Y=X Low output b a c w0 u0 XA High output

16. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f(, e) YA Y=X Low output b u1 a c w1 w0 u0 XA High output

17. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f(, e) YA Y=X Low output r b u1 a c w1 w0 u0 XA High output

18. Figure 2: Optimal contract for worker A ‘certainty line’ W=f(Q) Q=f(, e) YA Y=X Low output r b u1 a c w1 w0 u0 XA fixed Variable High output

19. 3. Do incentives work? • Yes, ‘Old Pay’ versus ‘New Pay’ • ‘Old pay’ systems • job evaluated grade-wage structure • pay = f(time, seniority, job characteristics) • ‘New Pay’ systems • Pay related to firm’s strategy • Flexible & variable pay systems • Higher pay for workers with more competence i.e. skills & knowledge

20. Types of incentive scheme • (i) Performance-related pay • (ii) Piece rates: w = f(Q) • (iii) Commission on sales • (iv) Group-based PRP I.e. bonus systems (US = ‘gainsharing’) • (v) Profit sharing