VII. Pay for Performance

1. VII. Pay for Performance

2. 2 Why not pay by output? 1st principle of optimal insurance: the party who can more easily absorb risk (ie the party that is most risk neutral) should insure the other party. employees are likely to be more risk averse than the firm. The firm should not avoid risks if this leads to lower profits. Stockholders can diversity risk across investments. They want the firm to earn the highest profit possible. Therefore the firm should insure the employees the firm can pay lower wages if it accepts the risk firms that pay by output will need to pay higher compensation. If they do not get greater productivity, it is a waste

3. 3 Why not pay by output? Sometimes output is difficult to measure it is possible that variations in output are due to external factors that are not controllable by the employee. Unless the firm can condition on these factors (ie use RELATIVE measures), it may be difficult to give the proper incentives. If the work of the employee depends upon coordination with other employees, it may be difficult to single out their individual contribution. It may be necessary to pay on a team basis. There may be multiple tasks. Incentives must be balanced across different tasks. If it is difficult to measure the performance on one task, strong incentives on other tasks will result in the employee ignoring that task. There can be a severe problem of distortion of incentives.

4. 4 Why not pay by output? It may be difficult to set the rate. Workers have incentives to slow down when you are attempting to set the appropriate rate. Management has the incentive to increase the required rate when the workers easily surpass their old levels of productivity. This is called the ratchet effect. Since workers realize that the ratchet effect exists, they will be reluctant to work to their full capacities or they may try to force other workers to work at less than full capacity.

5. 5 Why not pay by output? It may be costly to monitor output Paying by output can reduce the quality of output. It is possible that workers try to sabotage others. There is no incentive to cooperate. Changing the pay mix will typically result in an increase in turnover.

6. 6 Why choose output based pay? Positive influence on hiring and retention also known as adverse selection low ability workers will look for jobs that pay by input rather than output workers who do not want to work hard are likely to leave the firm. This is good.

7. 7 Why choose output based pay? Motivates current workers to work hard. also known as moral hazard or shirking Shirking does not imply that workers are bad persons. If monetary incentives are not given, then something else must be put in their place This is not just a result of agency theory, but could be predicted by expectancy theory or reinforcement theory.

8. 8 1. How Strong Should Incentives Be? Our goal: motivate employees to act like owners & maximize firm value Let�s use the most common form of pay for performance (linear): Pay = a + b�PM a = base salary; b = commission rate PM = performance measure We want to think about how to set a & b �

9. 9 1a. Level v. Shape of Pay If the employee works harder, what happens to pay? dPay/dPM = b = slope does not depend on the intercept the employee has greater incentives if effort has greater effect on productivity the commission rate b is higher Incentive is driven primarily by b, not by base salary a since our focus is on incentives, we care more about what determines b

10. 10 Implications b is often referred to as the �incentive intensity� larger b � stronger incentives we discuss more elaborate pay-performance �shapes� below a & overall level of pay has less effect on incentives depends on labor market value of employee�s skills also must compensate for employee�s effort cost C(Sei), riskiness of pay Use a 2-stage process in designing pay plans 1. focus on getting incentives right: performance evaluation & b 2. adjust overall level of pay a to attract & retain appropriate talent

11. 11 1b. Marginal Costs & Benefits of Effort Suppose the employee provides a little more effort on some dimension of performance This imposes a cost on the employee, DC/Dei the firm has the same marginal costs of extra effort as the employee must compensate the employee for working harder, so the firm�s costs must go up by the at least the same amount similarly, any increase in pay risk to the employee must be compensated They do not necessarily have the same marginal benefits of extra effort, however employee�s benefit is (DPay/DPM)�(DPM/De) = b�(DPM/De) firm�s is DQ/De if these are not equal, we have a conflict of interest & imperfect incentives

12. 12 �Perfect� Incentives We concluded last lecture that incentive problems arise b/c of conflict of interest (different benefits) between the worker & firm what incentive intensity b gives the employee the same interests as the owner�maximize profits? e.g., consider giving employee either 25% or 50% of profits they create which will give stronger incentives? what is the limit of this argument? No conflict of interest only if b is set so that b�(DPM/De) = DQ/De e.g., if PM = Q+?, b must equal 1 more generally, b must rescale the PM so that the employee gets 100% of incremental profits he or she creates for linear pay, b = Q/PM � if not, incentives are weak compared to ownership But if b = Q/PM, pay = a+Q, & firm profits from the employee = �a !

13. 13 Selling the Job Our solution amounts to �selling the job� to the employee profit = Q � [a + b�PM] = �a firm profits > 0 only if a < 0 all marginal profits go to the employee, who pays the firm for right to earn them Examples cab drivers seats on exchanges Berghof outsourced sales other? Many jobs have �sell the job� aspects to them

14. 14 �Practical� Incentives Even CEOs (& most other employees), aren�t usually rewarded with 100% of the profits they create. Why not? upcoming reading: Jensen & Murphy on CEO pay Suppose we cannot perfectly measure performance; PM = Q + e pay = a + b�(Q+e) = a + b�Q + b�e spay = b�se pay is risky if there is measurement error; the stronger the incentive, the greater the risk Implications pay risk premium thru higher total pay, & / or incur costs to evaluate performance more accurately, & / or give weaker incentives Because of measurement error, incentives are imperfect (weaker than ownership) in essentially all jobs

15. 15 1c. Multitask Incentives Suppose the employee�s job has two dimensions e.g., quantity & quality suppose performance on one dimension (quantity) can be measured accurately, but the other (quality) cannot The theory just developed implies that we should put a strong incentive on quantity, & a weak one on quality but that would distort incentives to reduce distortions, we need to balance incentives across different tasks our discussion of narrow performance measures was a special case: with a narrow measure, some tasks are given zero weight Where balance is difficult b/c accuracy of measures on different tasks is very different, explicit incentives are often set to zero implicit incentives based on subjective evaluations are used instead

16. 16 1d. Summary:When to Give Stronger Incentives Sorting for talent is more important Effort is more costly & has greater impact dC/de larger dQ/de larger (& Q more valuable in the market) Risk aversion is lower Incentives are well balanced across important tasks Performance evaluation is more effective measurement error s� is lower; measurement cost is lower performance measure distorts less & can be manipulated less subjective evaluator has better judgment, & is more trusted

17. 17 2. More Elaborate Pay-Performance SIhapes

22. 22 Summary: Pay�Performance Shape Upside potential / downside risk from employee actions � reward or punishment shape Simplicity is a virtue All jobs have implicit incentives promotions are most important for most firms, middle managers

23. 23 Targets Floors reduce employee�s downside risk can facilitate stronger incentives change incentives for risk taking ex.: employee stock options Caps may reduce gaming, but can hurt recruitment / retention Targets often motivate gaming if performance is near the target �Goldbricking�

24. 24 The Ratchet Effect If an employee earns high pay from an incentive, the firm may be tempted to change the plan to lower pay But doing so may reduce future incentives b/c of expectation that good performance today � lower rewards in future this is often called the �Ratchet Effect,� & is something to avoid �Quota Restriction� Two earlier course concepts help understand the issue the Hold-up problem � temptation to change the rules ex post implicit contracting & credibility / reputation

25. 25 3. Implementation of Pay for Performance Expect turnover Pay for performance (& luck) Transition gradually convert raises to bonuses provide initial insurance against downside risk, then phase out start with test cases & role models Communicate & listen Clearly reserve rights to adjust system over time Foster an appropriate culture

26. 26 Real World Examples Examples: REMAX - real estate agents pay $20,000 per year to REMAX for advertising, etc. They keep all the proceeds of the sales themselves Hairdressers - shop often sells spots. Individual keeps all sales. Taxicabs - often pay a flat fee per day to rent the cab Securities traders � Buy seat for $100,000s Waiters or waitresses Anywhere with a small base salary (opportunity cost) Salespersons with quota

27. 27 4. Economic Ideas Selling the job as an intuitive approach to moral hazard (agency) problems Tradeoff of risk v. incentives Incentive effects of shape v. level of pay Ratchet Effect

28. 28 Other Points Selling the job is a natural implication of our view of organizational design as an �internal market� & similar to our logic on GHC & screening To set targets effectively & reduce gaming invest in effective implicit contracting use subjective performance evaluations