Download Chapter 16

Economics of Strategy
Fifth Edition
Besanko, Dranove, Shanley, and Schaefer
Chapter 16
Performance Measurement
and Incentive in Firms
Slides by: Richard Ponarul, California State University, Chico
Copyright  2010 John Wiley  Sons, Inc.
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.
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.
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 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.
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
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-forperformance

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
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.
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 payfor-performance.
 It is relatively easy to find examples of destructive
effects of pay-for-performance.
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
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.
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.
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)
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
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.
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.
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.
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
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).
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.
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.