Incentives & Control

1. Incentives & Control

2. Question What great document was written in 1776?

3. Question Why are some countries rich and some poor? Answer The specialization of labor…

4. The Specialization of Labor • Do one task, do it well • Smith talked about movement away from self sufficient farms to urban model of specialized craftsman • Later taken to the extreme in Scientific Management • M. Hammer (1996) “When I tell people what I do for a living, I tell them that I am reversing the Industrial Revolution”

5. Industrial Revolution The widespread replacement of manual labor by machines that began in Britain in the 18th century and is still continuing in some parts of the world. The Industrial Revolution was the result of many fundamental, interrelated changes that transformed agricultural economies into industrial ones. The most immediate changes were in the nature of production. Goods that had traditionally been made in the home or in small workshops began to be manufactured in the factory. Productivity and technical efficiency grew dramatically, in part through the systematic application of scientific and practical knowledge to the manufacturing process. Efficiency was also enhanced when large groups of business enterprises were located within a limited area. The Industrial Revolution led to the growth of cities as people moved from rural areas into urban communities in search of work.

6. Taylor, F. (1929) The Principles of Scientific Management • Based on the idea that one can apply engineering principles to manage labor inputs in optimal fashion • Exemplified by Ford’s assembly line • Work is disaggregated (each worker performs a single motion). Work is simple, repetitive, routine, and highly structured; it requires low level of skill and judgment. • Tools: standards, statistics, mangers, formal reporting and coordination mechanisms

7. Taylorism • Develop a "science" for every job, including rules motion, standardized work implements, and proper working conditions. • Carefully select workers with the right abilities for the job. • Carefully train these workers to do the job, and give them proper incentives to cooperate with the job science. • Support these workers by planning their work and by smoothing the way as they go about their jobs.

8. Hawthorn Studies (Human Relations) • organizations are social systems, not just technical economic systems • we are motivated by many needs • we are not always logical • we are interdependent; our behavior is often shaped by the social context • informal work group is a major factor in determining attitudes and performance of individual workers • management is only one factor affecting behavior; the informal group often has a stronger impact • job roles are more complex than job descriptions would suggest; people act in many ways not covered by job descriptions • there is no automatic correlation between individual and organizational needs • communication channels cover both logical/economic aspects of an organization and feelings of people • teamwork is essential for cooperation and sound technical decisions • leadership should be modified to include concepts of human relations • job satisfaction will lead to higher job productivity • management requires effective social skills, not just technical skills

9. The Professional Manager • Berle, A.A. and G.C. Means (1932) The Modern Corporation and Private Property Large companies are no longer run by the people that own them – isn’t this a problem??? Yes….Leads to Agency Conflicts

10. Potential Locations of Agency SFA CRM CSS • Stockholders • Board of Directors • Senior management • Middle managers • Line employees • Customers

11. Agency Sources • Potential divergence of interest • Basis of gainful exchange or transaction • Difficulties in monitoring and enforcing • You do not bear the full consequences of your actions

12. Solutions Internal • Improve monitoring • Explicit incentive contracts. Linking pay to some operational output – bonuses, options. • Achieving goal congruence – equity positions • Peer Approval • Signalling!!!! External • Competing sources of information • Monitoring by markets (takeovers) • Sources of social governance eg. reputation, peer approval, morals, religion, culture

13. Labor Markets • Primary: Internal labor markets, insulated from free market mechanisms of secondary markets. Incentives via opportunity of promotion. • Secondary: Skills paid at market rate, often hourly basis. • eLance economy? Are the boundaries between primary and secondary markets dissolving?

14. Promotions as Tournaments • Require only ordinal information about who did better rather than cardinal of absolute performance data • Relative performance evaluation controls for the exogenous factors that affect all individuals • Bonus pool set in advance, employer has no reason to misrepresent employee's performance to safe on performance bonus payments • Mitigates the need to bargain individually with employees over salary • Negative correlation between open position and salary differentials

15. Tenure & Partnership • up or out • low level jobs continuously turned over • fresh ideas and outside perspectives • close evaluation of outside candidates • incentives to hold junior people down as source of rents destroys incentives and ruins recruiting • Recent tendency of Big 3 extending equity positions down to lower levels… Why?

16. Property Rights Why are some countries rich and some poor? D. North • "Economic growth will occur if property rights make it worthwhile to undertake socially productive activity". • Property rights should be clearly assigned, secure and transferable. (Pollution caused by the absence of well defined property rights – negative externality) • High complementarily + high specificity + uncertainty monitoring difficulty= integration

17. Equity & Partnership complementary assets should be owned by the same agent where complete contracts are impossible. “People are our greatest resource” Human knowledge can be bounded, socially embedded, tacit, context dependant, idiosyncratic, inalienable, sticky… = complementary assets cannot be owned by single agent Incentive Misalignment/Agency

18. Compensation Policy • Deal with uncertainties in earnings opportunities • Signal what organization values and what behavior and attitudes it wants to discourage • Help employees decide how to allocate their time and effort among competing ends • Reward accomplishments/success and failures • Provide motivation for behavior which contributes to organizational success • Meet employees needs for material consumption, equity, status

19. Piece Rate • Some studies have indicated that productivity increases of 15-35% with implementation of piece rate. • Strong motivators • Elicit self-selection • Easily understood

20. Piece Rate Disadvantages • Variance in relationship between output and effort required • Exogenous, random variables can affect worker income • May contradict logic of assembly line production models • Encourages employees to ignore other valuable activities for company, unlikely to help or cooperate other employees

21. Group Incentives • Determining individual performance may be impossible • Groups have better information about contributions than employers • Groups are thus better monitors of one another • Groups effective systems of internal behavioral governance • Groups encourage cooperation • Group synergies to work in teams more responsive to incentives

22. Where to place decision rights? Bird’s eye coordination Centralized Decision Information Costs Agency Costs Decentralized Local information Where combined costs (Int CC) are minimized

23. Internal Coordination Costs

24. External Coordination Costs? Market Coordination Search costs Transportation costs Operational Inventory holding costs External Communication costs Coordination Costs Costs of writing contracts Costs of enforcing contracts Contractual

25. Optimal Firm Size Total Cost Internal Coordination & Operations Costs Transaction Costs Optimal Firm Size

26. Specific and General Knowledge • “It is with respect to this that practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made only if the decisions depending on it are made with his active cooperation” (Hayek, 1945, p. 521-522)

27. The IS Problem There are two immediate options when attempting to co-locate knowledge and decision rights. • Moving the knowledge to those who make decisions • Move the decision rights to those who have the knowledge Consequences • A centralized system of control leads to high information transferal costs and low agency costs • A decentralized system leads to high agency costs and lower information costs

28. The IS Problem: Who cares??? Affects issues of: • Organization • Geographic location • Process definition and standardization • “Virtual” value chain coordination Dependant upon: • Uncertainty • Task definition • Interdependence • Risk

29. Old Economy or New Economy? • Data is visual, tactile and obtained directly from customers, suppliers and work • Workers tend to stay with firm because of pay schemes and benefits • Increasingly look outside of work for personal gratification and identity • Work is tightly integrated into family life and community • Emphasis on “tight control” of the production process through development of strict standards, policies and detailed procedures

30. Old Economy or New Economy? • Increased isolation of workers from each other and family and community • Opportunities for career development are limited except for as related to increased skill and expertise • Development of professional supervisor & middle manager roles; required to monitor work, control effort and output • Autonomous work teams are “empowered” to define work and manage production

31. Reengineering • Computers can gather most information more accurately and cost-effectively than people, they can produce summaries with electronic speeds, and they can transmit the information to decision-makers with the speed of light. Most interesting for our purposes is that, frequently, this information is so good and the analysis so precise that an executive decision is no longer required. . . . Anyone restructuring a company that does not take this new employee empowerment into account is not dealing with the future but is merely streamlining the past

32. Reengineering Principles • Organize around outcomes, not tasks • Have those that use the output of the process, perform the process • Subsume information-processing work into the real work that produces the information • Treat geographically dispersed resources as though they were centralized • Link parallel activities instead of integrating their results • Put the decision point where the work is performed, and build control into the process • Capture information once and at the source

33. Empowerment • Define wide boundaries of procedural decision making • Local sensitivity, responsiveness, • Give employees authority to capitalize on here and now.. Problems • Not always appropriate (risk, interdependence) • Moral hazard Solutions • Codify all alternatives in IT system, thus preempting uncertainty (dangerous) • Alternative, local governance mechanisms: e.g. teams

34. Across the hierarchy

35. ALKA Old sales process

36. ALKA New sales process Sales process reduced from 60 to 29 possible steps

37. ALKA Old claims adjustment

38. ALKA New claims adjustment Claims administration reduced from 139 to 44 possible steps Paper based claims administration reduced from 97% to 4.8% Average accident claim processing time reduced from 32 to 6 days

39. Teams: Cooperation & Rivalry • Knowledge sharing & tournaments • Acquisition & coordination of knowledge • Reduction of asymmetric information • Increase learning RIVALRY COOPERATION COOPERATION COOPERATION COOPERATION COOPERATION

40. Implicit Compensation • is often required when no explicit variables are readily available or easily measured. This is often the case with higher managerial positions, where the management of uncertainty is often required. • Empowerment can be seen as a move from an explicit to implicit incentive scheme. • Remember…Corporate Culture:Workable principles or routines of shared expectations that guide behavior in the face of uncertainty

41. Hawthorn Studies (Human Relations) • organizations are social systems, not just technical economic systems • we are motivated by many needs • we are not always logical • we are interdependent; our behavior is often shaped by the social context • informal work group is a major factor in determining attitudes and performance of individual workers • management is only one factor affecting behavior; the informal group often has a stronger impact • job roles are more complex than job descriptions would suggest; people act in many ways not covered by job descriptions • there is no automatic correlation between individual and organizational needs • communication channels cover both logical/economic aspects of an organization and feelings of people • teamwork is essential for cooperation and sound technical decisions • leadership should be modified to include concepts of human relations • job satisfaction will lead to higher job productivity • management requires effective social skills, not just technical skills