1

Economics of Strategy Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 16

Performance Measurement

and Incentive in Firms

Besanko, Dranove, Shanley, and Schaefer

Performance Measurement

Tying employees pay to performance can solve agency problems.

Pay-for-performance entails two costs.

Performance measures may be affected by random factors not under employees’ control

Performance measure may not capture all aspects of desired performance.

2

The Downside of Performance Measurement

Randomness subjects employees to risk.

Risk averse employees need to be compensate for risk that comes with the job

Employee may focus on tasks that brings more reward.

There could be a misalignment between corporate goals and employee decisions.

Risk Aversion

A risk averse person prefers a safe outcome to a risky outcome with the same expected value.

A risk averse person prefers a sure $100 over getting $160 and $40 with equal probabilities (expected value = $100).

Certainty equivalent is the dollar amount a risk averse person will accept in lieu of the uncertain outcome.

3

Certainty Equivalent

Safe outcome Preference

100.00 Safe outcome

99.00 Safe outcome

90.00 Safe outcome

80.00* Indifferent

70.00 Risky outcome

Comparison with a risky outcome of $160 or $40

with equal probabilities

Certainty Equivalent

This risk averse person finds $80 with certainty to be of the same value as the risky outcome ($160 or $40 with 0.5 probability each).

The certainty equivalent is $80.

The difference between the expected value of the risky outcome and its certainty equivalent ($20 in this case) is the risk premium.

4

Certainty Equivalent

For the same risky outcome the certainty equivalent will vary from person to person depending on how risk averse they are.

Certainty equivalent will be lower if for the same expected value there is a higher variability in the outcomes.

The concept of certainty equivalent can be used to rank risky outcomes in the order of their desirability for a given person.

Risk Neutrality and Risk Seeking

A risk neutral person is indifferent between two outcomes with the same expected value.

A risk seeker prefers a risky outcome to a safe outcome with the same expected value.

5

Risk Sharing

Risk averse persons can improve their situation through risk sharing.

Principle behind insurance – pooling of uncorrelated risk.

Pooling and sharing can reduce the variability without decreasing the expected value.

Risk Sharing

Two persons A and B are considering a risky outcome each

Each risky outcome has equal chance of paying $160 or $40

The risky outcomes are independent

The certainty equivalent is $80 for both A and B

6

Risk Sharing

Consider A trading half of his payoffs to B in exchange

for half of her payoffs.

Payoff for A, B Probability Payoff after trade

160, 160 0.25 160

160,40 0.25 100

40,160 0.25 100

40,40 0.25 40

Risk Sharing

The expected value stays at $100 after the pooling and sharing.

The variability has decreased since the probability of extreme outcomes is less.

The certainty equivalent should increase.

The risk premium will decrease.

7

Risk Sharing

If one person is risk neutral and the other is risk averse the risk should be traded away to the risk neutral person

Risk averse person values the payoff at $80 ($160 or $40 with equal probability)

Risk neutral person values it at $100

It makes for the risk neutral person to assume the risk

Risk and Incentives

A firm is likely to be less risk averse than its employees.

We will consider a risk neutral firm and a risk averse sales person to model the risk sharing problem.

Firm has many sales persons and the risk is pooled at the firm level.

If the firm’s stock is publicly traded its shareholders can diversify their portfolios.

8

Risk Sharing: Illustration

• Let sales depend on effort e and have a random component ε

• Sales = $100e + ε

• The random component ε has zero mean and variance σ2

Risk Sharing: Illustration

Assume that the certainty equivalent wage is E(Wage) - ½ ρ Var(Wage)

E(Wage)= Expected value of wage payment

ρ measures the risk aversion of the employee

Var(Wage)= Variance of wage payment

9

Risk Sharing: Illustration

Let F be the base pay and α be the commission rate

The employee’s cost of effort is zero until 40 units and 0.5(e - 40)2 thereafter

Employees certainty equivalent net of the cost of effort is

F + α(100e) - ½ (e – 40)2 -½ ρ α2 σ2

Risk Sharing: Illustration

Employee’s pay increases by 100α for each additional unit of effort

Equating marginal cost (e – 40) with marginal benefit, the employee puts in 40+100α units of effort

Assuming that ρ = 3 and σ2 = 10,000, the optimal α turns out to be 0.25

10

The Tradeoff between Risk & Incentives

Risk Sharing

Incentive component of pay can be made stronger if

Employee is less risk averse

Variance of performance measurement is smaller

Employee is less effort averse

Marginal return to effort is higher

11

Limitations of Performance Measures

Activities important to the firm may not be reflected in the performance measures. Test scores based incentives for teachers will shift their

efforts towards developing test taking skills instead of critical thinking skills

Activities detrimental to the firm may have a positive effect on the “performance measures.” Divisional profits used in incentive plans can lead to

conflicts over overhead cost allocation.

Limitations of Performance Measures

Possible solutions for the costs of pay-for-performance

Delink pay and performance

Redesign jobs to ensure rewards do not lead to neglect of certain tasks

Use subjective performance evaluation along with direct monitoring

12

Selecting Performance Measures

A good measure Should not have a huge random component

Should encourage desirable activities and discourage undesirable activities

Measures could be absolute measures or relative measures

Relative measures reduce risk due to common effects but may also encourage sabotage

Selecting Performance Measures

The choice could be between narrow measures (individual output) or broad measures (firm’s profit).

Broad measures reward employees for working with their colleagues.

Broad measure may be subject to more randomness than narrow measures.

13

Do Pay-for-Performance Incentives Work?

Compensation plans affect the way employees make decisions.

For simple jobs piece rate compensation improves productivity.

Pay-for-performance reduces performance along unmeasured dimensions.

Employees at job training agency focus on stronger candidates at the expense of weaker ones.

Evidence of Pay-for-Performance

In settings where the jobs are complex it is difficult to relate firm wide profitability to the use of pay-for-performance.

It is relatively easy to find examples of destructive effects of pay-for-performance.

14

Incentive Mechanisms

Implicit contracts

Subjective evaluation

Proportion tournaments

Threat of termination

Implicit Incentive Contracts

Explicit incentive contracts are contracts that can be enforced by a third party.

For many jobs, performance measures are not perfect.

Implicit contracts can work in the form of supervisor’s assessment

15

Implicit Incentive Contracts

To make implicit contracts work, the firm should

ensure that the employees perceive that the firm is acting in accordance with the contract

ensure that the performance standards are being applied consistently across the organization

communicate clearly with the employees in the event unforeseen conditions preclude the payment of the expected rewards

Subjective Performance Evaluation

Assessment takes into account factors that make it easy or difficult to attain the goals.

Supervisors’ reluctance to punish certain employees could lead to ratings compression.

Subjective assessments are subject to “influence” activity.

16

Subjective Performance Evaluation

To ensure that judgments by other employees are taken into account some firms use 360-degree peer review

Some use a fixed pool of points to allocate to employees

Grading on a curve can address “ratings compression”

Firms may limit influence activity by limiting access to decision makers

Promotion Tournaments

Since higher levels have fewer position than lower levels, not every worker can be promoted to the next level.

The contest among workers to be promoted to the next level is like an athletic tournament.

Promotion tournaments can provide incentives against shirking.

17

Promotion Tournaments

Promotions typically involve marked pay increases.

Employees have strong incentives to take actions that will enhance their chances of being promoted.

Promotion criteria are not typically part of an explicit contract.

Promotion Tournaments

Probability of promotion depends on effort

For office 1 given his effort choice e1 probability of promotion is p(e1)

Wage increase if promoted is (w* - w)

Cost of effort = c(e1)

Officer 1 maximizes

p(e1) (w* - w) - c(e1)

18

Promotion Tournaments

Contestant’s effort depends on marginal benefit of

effort (w* - w).

Firms can increase (w* - w) to make the

contestants work harder.

Can either raise w* or reduce w.

Promotion Tournaments

As the number of contestants increases, p(e1) decreases

The size of the prize (w* - w) should increase as

we have more contestants

If there are multiple levels of tournaments, the wage differentials increase with the level

19

Promotion Tournaments

Winning in one level gives the winners the chance to compete in the next level.

Advantages of promotion tournaments

“Winner-take-all” reward counteracts ratings compression.

Tournaments work as relative performance evaluation.

Disadvantage of Tournaments

Best performance in one level needs not indicate skills needed for the next level.

Tournaments can encourage sabotage.

20

Promotion Tournaments: Evidence

In large U. S. firms substantial pay increases are associated with promotions.

Wage differentials increase with rank.

Difference in pay between CEOs and corporate vice presidents is larger when the vice presidents are more numerous.

Firms with more vice presidents offer larger “prizes.”

Threat of Firing and Efficiency Wages

What constitutes “satisfactory” performance is commonly understood within the firm.

If performance is not satisfactory, worker is fired.

Firing is a punishment if wages are higher than what is available in the market.

21

Efficiency Wages

If employee keeps the job wage=w

If employee is fired wage=w**

Assume cost of effort=$50

Probability of detection, employee shirks=p

Employee will not shirk if p(w – w**) > 50

Efficiency Wage

To make employees not shirk, the firm can

increase p

increase w

Pool of unemployed workers provides incentives for the employed.

22

Efficiency Wages

Efficiency wages are useful when monitoring is difficult.

Non-wage benefits will make the jobs more valuable and have an incentive effect.

Efficiency Wages

“At-will employment” lowers the efficiency wage needed to provide the incentive to not shirk

If the legal environment makes firing harder efficiency wage has to increase

If firing is harder firms may choose alternate means of providing incentives

23

Incentive in Teams

To achieve the full benefits of team production, rewards need to be based on team output.

With team based performance measures, benefits from individuals actions are shared with the team.

Some beneficial actions may not be undertaken.

Incentive in Teams

If total benefit form action > total cost of action, it is a value creating action.

Action will be undertaken only if total cost < (total benefit)/n (n= number of members in the team)

Every team member lacks the incentive to take valuable actions (free rider problem).

24

Incentives in Teams

Free rider problem is exacerbated if a team member has another task on which he works alone.

Weaker incentives for team-based tasks will result in shift of effort to the individual-based task.

Evidence on Incentive in Teams

In medical practices, increase in the size of partnerships lead to reductions in individual productivity.

Larger law firms are less able to control costs compared with smaller firms.

25

Incentives in Teams – Solutions

Team size can be kept small.

Team members can be made to cooperate by allowing them to work together for long periods.

Teams can be structured so that team members can monitor each other.

Copyright © 2010 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of this work beyond

that permitted in section 117 of the1976 United States Copyright Act

without express permission from the copyright owner is unlawful.

Requests for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser may

make back-up copies for his/her own use only and not for distribution

or resale. The Publisher assumes no responsibility for errors,

omissions, or damages caused by the use of these programs or from

the use of the information herein.