178.307 Markets, Firms and Consumers

178.307 Markets, Firms and Consumers Lecture 3- Human Resource Management

Background Readings 5: p126-32, 154-59 6: p167-70, 179-83 8: p250-54 Chapters 12-13 Peter Earl Canice Prendergast Key Concepts Bounded Rationality-Incomplete Contracts Signalling Moral Hazard Principal-Agent Theory Shirking Efficiency Wages Overview

Human Resource Management • Principal-Agent Theory • At least 2 parties to the contract • The agent has different preferences to the principal • Monitoring is costly

Bounded Rationality Contrast with global rationality Earl p720-74 Originates with Simon People seek satisficing solutions Incomplete Contracts arise from Bounded rationality Unforseen circumstances Costly contracting and calculating Imprecision of language Why Can’t Contracts Eliminate Principal-Agent Problem?

Incomplete Contracts • Incomplete Contracts arise from • Bounded rationality • Unforseen circumstances • Costly contracting and calculating • Imprecision of language

Signalling • Signalling can mitigate incomplete contracts • Agents have private information they are unwilling to reveal • Players may use signals instead to indicate their true type • Spence & Education Average MP= q + 2(1-q) = w

Imitative Strategies: Monarchs and Viceroys

Now introduce education • For L, cL = y • For H, cH = ½y • Define a critical value of y* • If y ≥ y*, w = 2 • If y < y*, w = 1

Signalling Equilibrium cL Wage 2 cH 1 y* 1 2 Education- y

Definition Post-contractual opportunism Workers shirk Managers exaggerate difficulty of tasks These are instances of Principal-Agent problems Shirking “Hardly a competent worker can be found who does not devote a considerable amount of time to studying just how slowly he can work and still convince his employer that he is going at a good pace” Taylor Moral Hazard

Shirking Game

h is inspection cost g is effort from working w is wages v is value of output g > h > 0 w > g There is no pure strategy equilibrium to this game. There is a mixed strategy p* = h/w q* = g/w Solutions

Air-Traffic Controllers Changes in the early 70s made disabilities easier to claim Counterintuitive Results 5+ years experience more likely to ‘punch out’ System errors increase in ‘light periods’. Managerial Misbehaviour Takeovers threaten poor managers Managerial resistance to takeovers common. Poison pills may be adopted. Rights to buy shares at low prices Poison pills reduce share value. Examples of Shirking

Why aren’t workers taken on at lower wages? Suppose workers can put forward a positive effort e>0, or shirk e=0. Probability of detecting shirking is x The worker’s utility is: Efficiency Wages

No Shirking Conditions • The firm must pay more than the alternative wage and the cost of effort (e) • It is a solution to shirking • Social cost is unemployment and foregone production

Explicit Incentive Pay Piece rates Advantages Disadvantages Sales Commissions Pay for Skills Performance Pay Group Incentives Profit Sharing Gain sharing Effectiveness of Group Incentive Contracts Risk sharing Pay equity Other Compensation Schemes

Managerial Compensation • Motivating Risk Taking • The puzzle • Human capital risk • Inducing risk-taking • Paying for investment proposals • Deferred compensation • Other issues- Franchising

References • Economics and Psychology: A Survey Peter E. EarlThe Economic Journal 100(402): (Sep., 1990), pp. 718-755 http://links.jstor.org/sici?sici=0013-0133%28199009%29100%3A402%3C718%3AEAPAS%3E2.0.CO%3B2-I • The Provision of Incentives in Firms Canice PrendergastJournal of Economic Literature > Vol. 37, No. 1 (Mar., 1999), pp. 7-63 http://links.jstor.org/sici?sici=0022-0515%28199903%2937%3A1%3C7%3ATPOIIF%3E2.0.CO%3B2-%23 • Incentive Conflicts and Contractual Restraints: Evidence from Franchising James A. BrickleyJournal of Law and Economics > Vol. 42, No. 2 (Oct., 1999), pp. 745-774 http://links.jstor.org/sici?sici=0022-2186%28199910%2942%3A2%3C745%3AICACRE%3E2.0.CO%3B2-6

178.307 Markets, Firms and Consumers