Incentives, Lecture Notes - Economics, Study notes of Economic Theory

Incentives, Lecture Notes - Economics, Harvard University (MA), United States of America (USA),Oliver S. Hart,Economics, Incentives

Typology: Study notes

2010/2011

Uploaded on 11/02/2011

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Overview: Incentives & employment
Case discussion : 'Outsourcing Sales'
Specialization & Comparative Advantage
Principal-Agent Problems
– Pay for performance
– Promotion Tournaments
Moral Hazard
Set-up : “Outsourcing Sales?”
TV station considers outsourcing sales
Sales company asks variable compensation:
10% on first $400 million
5% on part between $400 and $600 million
2% on sales above $600 million
Sales costs are all variable
TV Station has
$500 million advertising revenue
$450 million fixed costs
$50 million variable cost from sales
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pf4
pf5
pf8
pf9
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Overview: Incentives & employment

• Case discussion : 'Outsourcing Sales'

• Specialization & Comparative Advantage

• Principal-Agent Problems

  • Pay for performance
  • Promotion Tournaments

• Moral Hazard

Set-up : “Outsourcing Sales?”

  • TV station considers outsourcing sales
  • Sales company asks variable compensation:
    • 10% on first $400 million
    • 5% on part between $400 and $600 million
    • 2% on sales above $600 million
  • Sales costs are all variable
  • TV Station has
    • $500 million advertising revenue
    • $450 million fixed costs
    • $50 million variable cost from sales

Outsourcing Sales?

Assume first that sales company has same MC as TV station

$

Specialization

  • Specialization on individual and firm level
  • Advantages
    • Scale effects
    • Learning effects
    • Less change-over costs
    • Comparative advantage
  • Disadvantages
    • Causes motivation (incentives) and coordination problems
    • Dependency fears may lead to duplication and under- investment

Comparative Advantage: Example

  • To produce a line of code, it needs to be programmed and debugged
  • Productivity (lines per day)

Program Debug Anna 3 2 Barry 2 1

  • Optimal solution:
    • Specialize: Anna debugs and Barry programs
    • This gives 2 lines per day (vs. 1.87 if they work on their own)

Comparative Advantage

  • Key Insight : Relative productivity (lines programmed / line debugged) : 1.5 for A vs. 2 for B => B should do the programming and A the debugging
  • Principle of Comparative Advantage :
    1. What matters in allocation of tasks is comparative advantage, not absolute advantage.
    2. Whenever there are differences in relative productivity, there are gains from specialization and trade.
  • Note: CA is also important in international trade

Solutions

  • Monitoring
    • Requires carrot & stick: efficiency wage, bonuses, employee’s reputation
    • More effective in repeated relationship
  • Incentive schemes (i.e. method of compensation)
    • Pay for performance
      • Commissions, piece rates
      • Lawyers: fixed fee, hourly rate, or contingency
      • Doctors: fee for service
    • Promotion tournaments
  • Intrinsic motivation via selection and socialization
  • Integration (for firms) ... but same issues remain

Pay for Performance

• Output per worker typically goes up

• Sorting: most productive workers stay

  • Also causes productivity to go up.
  • Average wage may increase.
  • Note : sorting is a leading source of misinterpreted analyses. - Productivity goes up after pay for performance is introduced : money makes people work harder? - Do MBA's earn more than others in professional firms?

Issues with Pay for Performance

  • Difficult to get correct incentives
    • 'Outsourcing sales' issue applies broadly : α MR = MC instead of MR = MC
  • You get what you pay for
    • Caesarean sections
    • Evaluating teachers by test performance
    • Stock options for executives
    • Typist at Lincoln Electric
    • Multi-tasking problems
  • Agent bears part of risk and requires risk premium

Backloaded wages and rewards

  • To prevent employees from shirking, make it very costly to get fired.
  • Efficiency wages (i.e. paying more than market wage) are costly.
  • Solution: pay part of the wage at the end of career - Pensions - Backloaded wages (underpay when young, overpay when old) in form of increasing wage profile - Note: increasing wage profile might also reflect increase in skills

Moral Hazard

  • Principal-Agent problem is part of larger problem: unobservability of actions or hidden behavior.
  • Imperfect information can encourage people to behave in "incorrect" ways.
  • Moral Hazard in Insurance Markets
    • Car Insurance - would you drive differently if you didn't have insurance?
    • Health Insurance - would you behave differently if you didn't have health insurance?

Moral Hazard: The RAND Health

Insurance Experiment

Copayment Expenditures on

Rate Medical Care

0% (free) 417

Take Away Points

  • Comparative Advantage is an important reason for specialization and trade.
  • The Principal Agent problem is fundamental to understanding many aspects of employment relationship.
  • Potential solutions include monitoring, pay for performance, and promotion tournaments.
  • With any incentive plan, it is important to take the other's perspective, to understand their real incentives.