6-3 Incentives and Compensation
[6.2 Asymmetric Information and Signalling]
This topic provides an introduction to the economic theory of incentives. It will focus on how incentive considerations change compensation contracts. Throughout the topic, the basic issue is that individual employees have better information about their own activities than their employers do. However, employers can make imperfect observations about an employee’s performance. Consequently, by basing pay on performance, employers might achieve higher productivity than pay that is a simple time-based rate, eg, daily or hourly.
A firm can pay its employees in one
of two ways. The first, and most common way, is an hourly wage (or monthly or
annual salary). This is known as input-based pay. The second, based on some
measure of performance, is called output-based pay.
Generally, output-based pay makes people to put in more effort. It also tends to attract and retain employees hoping to earn more pay than with a simple base salary. Less productive workers will prefer to work where they are guaranteed a fixed salary and thus will avoid a company with an output-based pay scheme. Over time, this will increase the average productivity of a company's workforce.
Incentives
Most output-based pay schemes are combinations of base salary and incentives. Incentives can take different forms, each with different effects on employee performance, effort and output. Some of these effects will be desirable to the firm, and others will not.
When
Do Incentives Work?
Firms offer incentives to get their
employees to increase their effort in specific ways that benefit the company.
This effort can take several forms: how hard they work, the quality of their
work or how persistent they are at solving problems.
People apply effort to the problems
of the firm when they are motivated to do so, in many cases by some incentive.
The effort given in response to an incentive depends on two main factors.
First, the employees must value the incentive. The more highly
valued the incentive, the more effort employees will make. Thus, larger
incentives should lead to increased effort.
Second, the employees must believe
in the probability of success. In
other words, they must believe that their efforts will lead to receipt of the
incentive. If the employee believes their efforts will lead to success, then
they will put in more effort. The higher the belief in success, the more effort
they will provide. The employee must also believe that if they attain the
required level of performance, the incentive will actually be forthcoming from
the firm. The more the employee believes that their efforts will not be
rewarded, the less effort they will put in.
Click the link here to see how these two factors interact.
Incentive Pay
Structure
When designing the incentive portion of total
pay, consider the relationship between pay and performance, or the
"shape" of the pay function.
The simplest incentive pay structure – with pay directly corresponding to output – is linear. For example, itinerant farm workers are often paid on a "piece rate" by the barrel or box. The more boxes filled with the harvest, the more pay they receive, which leads these workers to want to harvest as much as they possibly can. Another piece rate is the commission earned by a salesperson. The commission rate is usually a set amount or percentage of each sale made. Higher commission rates provide a higher level of incentive than lower commission rates.
There are many variations. Some firms pay incentives only after a
certain minimum output level is achieved. Others put a limit on the amount an
employee can earn through incentives. Each of these will motivate different
levels and types of performance.
Click on the link here to find out why employees prefer constant to variable pay.
There are also non-linear incentive
schemes. For example, an employee could receive a lump-sum bonus for achieving
a given level of output. Firms also use "hybrid schemes", which are a
combination of linear pay schemes and lump-sum bonuses.
All of these schemes share one
common element: as output increases, pay increases.
How
"Intense" Should Incentives Be?
The incentive portion of an
employee's pay can be described as the incentive intensity multiplied by the
performance measures. The incentive intensity represents the slope of the pay curve. The more intense the
incentive, the more the employee wants to increase the level of the specific
performance measure.
As the incremental benefit (eg, the piece rate) grows, a worker will exert more effort. He or she will continue to work harder until the incremental cost of more effort (ie, picking one more piece of fruit) is equal to the incremental benefit they receive from that effort.
Pay
versus Effort
Because effort also causes
"pain", there is a limit to the amount of effort an employee will
provide. Rather than physical pain, the word is used to reflect a combination
of various aspects of difficulty of work, such as stress, diligence,
concentration and additional hours. At some point, each employee will find that
the extra effort is simply not worth the pain.
Think in terms of the marginal
benefit, or incremental pay, and the marginal cost, or incremental pain, of
working harder. So long as the marginal benefit is greater than the marginal
cost, you want to work harder; if the marginal benefit becomes less than the
marginal cost, you want to ease up. You will keep on working harder until the
point where the marginal benefits equal the marginal costs.
View the following animation for more about pay versus effort.
You have just seen a relationship between pay and effort for the Point-E sales team. To see how this relationship is affected by changing economic conditions, view the animation here.
Now try the following exercise, which allows you to apply the knowledge you have learned about pay versus effort. Click here to launch the exercise.
Selling the Job
If farmers paid their itinerant
workers the full market value for each box of fruit picked, they would receive
no profits. But if they reduced the incentive intensity by offering less per
box of fruit, employees would pick less. A solution to this is to "sell
the job" to the farm worker, basically charging him or her for the right
to come to the farm and pick the fruit.
How is this "rental rate" determined? It is based on the
worker's best alternative. So the expected value to the employee of the amount
he or she earns from harvesting fruit less the rental rate must be at least as
high as the next best use of the worker's time (leisure or other job
opportunities).
Click the link here to find out how selling the job fits the pay model.
These pay schemes are often
instituted to give the employee a feeling of firm ownership. Because the
employee's fortunes are linked to those of the company, the employee feels like
a part owner. This is particularly true when compensation is based on
activities that increase firm value.
There are five basic pay-for-performance pay schemes. To read more about them, click the link here.
Multitask Incentives
Most jobs have multiple dimensions and many tasks for the employee
to perform. Some tasks improve firm value more than others. Some may even
reduce firm value. How do you motivate your employees to perform the right tasks?
To illustrate, consider a for-profit
medical clinic. In the past, such clinics paid little attention to the
incentives provided to the physicians. Today, however, with skyrocketing
medical costs, expensive treatments must be allocated with great care to
provide the best balance of treatment to all patients. Therefore, medical
clinics face the delicate issue of trying to motivate doctors to consider cost
as well as quality in treating their patients.
Doctors can spend their energy and
time on many tasks in the course of doing the job. These include tasks that
improve the quality of the patient's care, affect patient satisfaction (and
likelihood of returning for future care), involve management of nurses and
other personnel and so on.
Suppose a doctor may choose one of
two treatments for a chronic sinus condition. One – taking a relatively inexpensive medicine for three weeks – gradually cures the
condition over time. The other, a very expensive medicine, can heal the
condition more quickly but at a very high cost.
With no incentive, the doctor is
likely to prescribe the expensive medicine. Doctors take personal pride in
healing their patients quickly. However, this may not be the optimal outcome
for the employer. Instead, the medical clinic may prefer that the doctor
prescribe the cheaper, slower medicine. This is an example of an action that the
doctor does not want to take but that the employer wants the doctor to take.
Task
Matrix
Now consider this two-by-two matrix
describing potential tasks in an employee's job.
There are some job tasks that the
employee normally does not need to be motivated to do, because the employee
enjoys those parts of the job or takes pride in them. Other tasks, the employee
prefers not to do (eg, the doctor prefers tasks that improve the quality of his
or her care, but does not like to worry about controlling costs). On the other
hand, the employer cares about both sets of tasks (the clinic cares about
quality and controlling costs). Sometimes the clinic agrees with the doctor and
prefers a treatment that emphasises quality. Other times, however, the clinic
prefers a more cost-effective treatment.
Thus, there are four categories of
tasks. In the upper-left and lower-right cells above, there is no conflict
between the employer and employee. In the upper-right and lower-left cells,
however, there is a conflict of interest. These kinds of job tasks require
incentives to motivate the employee to do more of the task (the upper-right
cell) or less of the task (the lower-left cell).
Choosing Measures
Basing a reward (a promotion or bonus) on a single measure can provide implicit multitask incentives. Most performance measures are affected by many tasks performed by the employee. As long as these are weighted appropriately in the overall performance measure, the employee will have good incentives to perform all of these aspects of the job. For example, chief executive officers (CEO) are often rewarded for stock price performance. This performance measure is a good approximation of overall, long-term firm value, so it provides good, balanced incentives for the different tasks in the CEO's job.
Most jobs do not have such broad,
well-balanced performance measures available. An alternative is to give several
bonuses based on different measures. For example, in auto dealerships, department
managers are frequently given separate bonuses for measures of department
profit, employee productivity and customer satisfaction. In the case of the
doctor, it might be possible to provide incentives based on both patient health
and cost control.
However, this approach is not always
feasible. For example, if it is easy to measure the doctor's cost control
actions with high accuracy, then the employer should put a strong incentive on
this measure. But if patient health and quality of treatment are highly
subjective and difficult to measure objectively, then any measure of these is
likely to be inaccurate, imposing risk on the doctor. Thus, the firm should put
weak incentives on such a risky measure.
Placing strong incentives on cost
control and weak incentives on quality of care, however, does not provide
balanced incentives across these tasks. This is not unusual; many jobs have
qualitative aspects that are difficult to measure and other aspects that are
easy to measure. It is often difficult to design balanced incentives across
such different types of measures.
In such cases, firms often make extensive use of subjective
performance evaluations rather than relying heavily on a pay-for-performance
strategy.
The general point is that incentives are more difficult and subtle
to provide for jobs with more than one task. Pay careful attention to what
tasks are being emphasised (and not) in the performance measure. A good rule of
thumb is that you get what you pay for.
Therefore, make sure that the incentives you give your employees pay for the
right things, in the right balance.
In a perfect world, an employee's
effort could be accurately measured and the employee paid accordingly. The more
effort an employee provided, the higher his or her pay. In general, however,
employee effort cannot be directly measured.
Performance measures gauge the effect of employee effort on firm value. Good compensation plans reward employees for taking actions that improve firm value -rewarding all of these actions if possible, while not rewarding actions that do not contribute to firm value. Good plans also avoid paying for random events that change firm value.
Performance
measures at the top
Imagine a CEO who is compensated only in company stock, making the firm value
his or her performance measure. The CEO's compensation rises and falls with the
value of the firm, providing an incentive to balance all possible actions and
take those contributing the most to firm value.
This very broad performance measure captures all possible actions
of the CEO. However, many factors outside the CEO's control, such as
macroeconomic forces and investor sentiment, affect firm value. The influence
of uncontrollable forces leads to measurement error, imposes risk on the CEO
and generally leads to a risk premium paid to the CEO.
To reduce risk, performance measures
are often narrowed. The CEO might receive base pay plus a bonus based on
accounting profits, making the CEO's pay more highly dependent on his or her
actions.
By using this performance measure, however, the firm is not
rewarding all parts of the job. The CEO could take actions that raise profits
without increasing firm value – or even actions that damage firm value. Narrowing the scope of
the measures introduces distortions, because the firm is now rewarding actions
that do not necessarily add value to the firm.
In addition, the CEO has an incentive to manipulate or "game" the accounting measures to receive more pay. If the CEO is successful, he or she will be rewarded for taking action that does nothing to increase the value of the firm.
Performance
measures throughout the hierarchy
Middle managers and even individual employees
can also be rewarded on either broad or narrow performance measures. The
broadest measure of performance is still firm value, but for most employees in
an organisation, many "uncontrollable" factors influence firm value.
Rewarding mid-level managers on firm performance captures more of their range
of possible actions that increase firm value, but it is more difficult to
calculate how much of that increase in firm value is attributable to their
actions. Therefore, this type of performance measure carries more risk for
managers. The firm usually responds by narrowing the measure. For example, a
division manager's performance measure might be divisional accounting profits
rather than company-wide profits.
Unfortunately, removing a number of
uncontrollable events also removes a large number of controllable actions from
the employee's reward structure. This creates incentives to focus on things
that improve his or her measure (division profits) but no incentive to engage
in additional behaviours that would increase the value of the firm (eg, helping
other divisions).
The key to choosing the right
performance measure is to find the right balance between risk for the employee
and behavourial distortion.
Group performance measures
Employee performance measures are
sometimes based on group outcomes. Creating performance measures at the group
level will generally increase co-operation within a group. If compensation
depends on contributions from all members, there will be a strong incentive for
individuals to work together. If group co-operation is critical to firm value,
the firm will want to choose group-based performance measures.
If performance measures are based on individual performance, then employees have little incentive to co-operate with others. In the extreme, relative performance evaluation may create an incentive to sabotage others' work.
One risk of group-based performance
measures is the free rider problem. The rewards of effort are distributed among group
members, yet the cost of that effort is borne completely by the employee. This
dilution effect lowers the incremental benefit and causes the employee to
reduce effort.
Individual employees within a group
may reduce their effort with the expectation that someone else will work harder
so that the group meets its objectives. Increased risk then falls on each of
the employees, causing all members of the group to reduce their effort.
This is not always the outcome, however. If rewards are based on group performance, then it is possible that the group will police itself and reduce the incidence of free riding. This creates a possible additional benefit from group incentives. If group members monitor each other, then the firm will be able to spend less on supervision and other monitoring methods.
Objective versus Subjective Measures
All
measures must eventually be quantified to determine the associated
performance-based pay. Objective performance measures include those that are
observable and verifiable. Subjective performance measures are not. Fully
subjective measures are simply announced by the firm or evaluator. Toward the
more objective end of the spectrum are more quantitative measures such as
accounting numbers. These measures tend to be more objective in that there is
less room for interpretation (though, because the employee or firm can massage
the numbers, they are not perfectly objective).
In general, objective performance measures are less susceptible to
gaming than subjective measures and therefore lead to less undesired lobbying
behaviour. Unfortunately, objective measures do not exist for most desirable
behaviours. For example, it is hard to come up with perfectly objective
criteria for "co-operation with others", which is becoming more
important in organisations.
Even objective performance measures sometimes create distortions.
The axiom "what gets measured gets done" often holds true; if the
firm focuses on objective performance measures, then employees will focus their
efforts on those items that are measured and de-emphasise work on subjectively
measured items.
Concerns about Output-Based
Incentives
For many jobs, particularly senior
management jobs, the company wants to motivate behaviour that increases its
long-term value. The problem with many performance measures, and output-based
pay in general, is that they cause employees to forsake actions that lead to
long-term value in favour of short-term actions that increase their pay.
This means that the firm must think about this type of behavioural
distortion when designing performance measures and try to find the right levels
of incentive power while minimising the distortion. One way to correct for the
distortion is to use stock options.
Click here for details on your discussion
activity.
Topic Summary
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When effort cannot be directly observed then it may be better to base pay on output.
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That care must be taken when setting incentives to respect the multiple tasks that employees engage in and how easily each of these can be measured.
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That when choosing performance measures it may be appropriate to sometimes use group level measures as well as measures that are more subjective. However, these measures have potential incentive costs.
You may now proceed to topic 6.4, “The
Hold-Up Problem”.