Incentives Matter

1
Incentives Matter

• If you would persuade, appeal to interest and
  not to reason.
• Benjamin Franklin
• Poor Richards Almanack
• 1732-1758

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Agency Costs

• Employees or contractors not behaving as they
  should is a part of what we call Agency Costs
  or Agency Problems.
• Agency costs are a problem whenever a principal
  hires an agent to act on his behalf. A boss hires
  a worker.
• Solving this universal problems is a key
  managerial problem in managing personnel and in
  controlling costs.

3
Why cant people be this nice?
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Drawback of Firms Agency Costs

• Agency costs arises from separation of ownership
  and control.
• Owners of firms are interested in profit
  maximization.
• Managers, employees, and suppliers are interested
  in maximizing their own self-interests.
• How do we give employees incentives to act as if
  they were owners of the firm?
• How do we get employees to not shirkthat is,
  work as hard as they can in the manner the owners
  would want? It is a matter of incentives.

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Basic Human Nature

• This is what most people want to do when they are
  supposed to be working
• This is what we want
• employees to be doing

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Agency Costs . . .

• These are a problem because we are human. If we
  cheat ourselves, then no one else bears the
  cost. So the one-person firm does not suffer
  agency costs.
• It is natural for us to want to exploit others
  get others to pay more than they agreed to pay or
  we produce less than we agreed to produce. A
  divergence in interest between principal and
  agent in a multi-person organization and in
  contracts.

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Monitoring

• We have incentives to shirk take more than we
  should or work less than we should. Monitoring is
  costly, so sensible to accept some losses. Many
  forms of monitoring exist (spot checks, etc.).
• Usually there is unequal (asymmetric) information
  between parties. One knows more than the other
  and can exploit that.
• Examples Person selling used car (seller
  exploits buyer)
• Buying insurance (buyer exploits seller)

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Monitoring, Bonding Signals

• How do we assure customers that we can be
  trusted, so they should deal with us?
• Various devices
• Fixed price contracts Bonds Warranties
• Take payment as later (Accenture)
• Less formal Reputation. This matters greatly in
  the market. Diamond market in New Yorkclose
  family, social and religious ties impose special
  discipline.

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Entrepreneurs and their Firms

• Key Managerial Problem
• Giving employees incentives to act as if they are
  owners.
• The entrepreneur or top manager must cede
  authority to others. The issue is How do we
  structure an organization to reduce agency costs?
  The movement has been in this direction
  especially in knowledge-based production.

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Decentralization Pros Cons

• Empowering workers and managers.
• BENEFITS
• 1. More effective use of local knowledge
• those closest know the most
• 2. Conservation of senior management
• top people cannot know or do everything
• 3. Training motivation for local managers
  helps attract and keep good managers and train
  future top managers

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Decentralization . . .

• Empowering workers and managers
• COSTS
• 1. Agency costs
• shirking self-dealing so control and
  monitoring measures needed
• 2. Coordination costs and failures
• duplication pricing errors
• 3. Less effective use of central information
• local managers cannot know all information the
  central managers have, so have inferior knowledge

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Team Production Increasing or Decreasing Costs?

• Create teams of people with different expertise
  to make decisions
• Ex.Hallmark Cards had teams of art, design,
  production and marketing assigned by holiday with
  decision rights rather than move produce from
  functional area to areacut time in half.
• BenefitsImproved use of specific knowledge and
  employee buy in due to better information, more
  cooperation less blame.
• CostsCollective-action and free-rider problems.
• Same thing in car productionteam development
  tried at Chrysler separate functional areas at
  GM. Tradeoffs.

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Getting Workers to Monitor Each Other

• Nucor has been one of the few successful steel
  makers in the U.S. It keeps management small and
  adapts new technology quickly.
• Production workers are in teams. Base salaries
  are below industry standards. Teams are given
  production goals. Beating goals allows salary to
  be more than doubled. Penalties for mistakes are
  severe, so quality maintained. If one worker
  shirks then everyone suffers.
• Who is likely to want to work at Nucor?

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Corporations Have Problems

• In sum, the corporate form of organization is not
  perfect.
• The alternativesnon-profits and government
  bureaushave far worse performance problems.
• Much of modern wealth is tied to the rise of the
  modern business organizationsgetting incentives
  right.

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Examples of Key Incentives

• From Charlie Munger, billionaire partner of
  Warren Buffett
• In start up organizations, stock options work
  wellincentive to get a big gain in the future.
• When Microsoft switched away from stock options
  to restricted stock, it made little progress.
  Why? Incentive was to preserve value instead of
  create new value.

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It Happens High Level and Low

• After 2005, the Merrill Lynch board approved new
  incentive program for the CEO and his senior
  colleagues raise return on equity in the next
  three years and you get rich. Given that
  incentive, what happened?
• 1. Merrill repurchased 9 billion of its existing
  stock to increase return to remaining stock.
• 2. Firm went more heavily in high-risk assets
  such as sub-prime mortgages (high risk high
  return).
• Result 2006 great! Short term thinking, not long.

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Other incentives

• Not everyone can have stock options. Cash bonuses
  work well at lower levelsa goal to strive
  forgetting a nice big payoff.
• BUTpeople respond to incentives so watch how
  rewards structured.
• Why the sub-prime mortgage mess? Banks paid
  lenders based on quantity of mortgages made, not
  quality. If pay for quantity, better have a
  quality measure in place toocharge back for
  failures (rather like car dealership repairmen).

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Are Incentives Right?

• Dealers at casinos in Las Vegas earn about
  100,000 per yearalmost all on tips. Their wages
  are about 12,000.
• Casino owner Steve Wynn ordered tip money pooled
  and shared with managers.
• Why?

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Question on Team Incentives

• Suppose different numbers of people are assigned
  to pull a rope as hard as you can.
• One person pulls the rope.
• Three people pull the rope together.
• Eight people pull the rope together.
• How does the pulling force (work effort) per
  person change across these three cases?

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Incentives of Managers

• In the fast-food industry, 30 of stores are
  company owned and run by a salaried manager. 70
  of the stores are run as franchises by
  owner-operators who split profits with the parent
  company.
• 1) Which kind of store would you think would
  tend to be more profitable?
• 2) Why then does the parent choose to own some?
  Where would they be located?
• 3) Would you expect employees to see a
  difference in the managers?