Market Failures & Incentive Issues inside the Firm given the following: Discuss the benefits of the 'efficiency wage' theorem for the firm and the quality employee.
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Chapter6MarketFailuresandIncentiveIssuesInsidetheFirm.pptPowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University
Market Failures and Incentive
Issues Inside the Firm
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CHAPTER 6
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Market Failures Inside the Firm
- Personnel policies
Important effect on the efficiency of the firm
Praise, nonmonetary awards, and titles
Compensation – money
Salary specified prior to the employee’s performance
Based on productivity
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Market Failures Inside the Firm
- Decisions
How many resources to devote to retention and training
Promote from within or go outside
Are morale and camaraderie of employees important?
What resources to devote to these issues
Working in teams or working alone?
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Public Goods
- Firm’s reputation – public good
Employees – no incentive to devote time or effort to the reputation-enhancing activities
Solution: assign property rights for the reputation of the firm to the employees
As long as monitoring is not too costly
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Teams
- Teams
Management technique, 1990s
Belief: team spirit
Spurs individual effort
Enhances the productivity of all
Output: team-oriented
Compensation: team-based
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Teams
- Benefit of teamwork
Greater total productivity
- Cost of teamwork
Free riding
When the effort of any member of the team is not easily observed
Team members - incentive to free ride
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Teams
- Minimizing free riding
Monitor - private property rights to the output of the team
To monitor the team’s performance
Issue: if individual actions are not observable
Solution: Base part of each team member’s pay on evaluations by the other team members
Profit sharing
Employees’ wages or pensions - based on the profits of the entire firm
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Business Insight
Free Riding in Japanese Firms
- Workplace
Hard workers resent “free riders”
- Japanese companies
People tend to stay with a single company their entire life
- Punishment for free riding
Peer pressure and guilt
Free riders - isolated and excluded from daily life in the firm
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Subjective Evaluations
- Subjective evaluations
Opinion
Supervisor rates the employee on the dimensions the firm has found to be important
Cooperative behavior
May create incentives for individuals to contribute to the public good
May result in inefficiencies
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Subjective Evaluations
- Inefficiencies of subjective evaluations
Rent seeking
Underlings may spend time “sucking up” to supervisors
If the supervisor responds to the rent-seeking actions of employees
Inefficient promotions, bonuses, and job assignments
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Subjective Evaluations
- Rules that minimize rent-seeking activities
Restrict what the supervisor can control
Use a committee rather than a single supervisor to carry out evaluations
Positions may be constrained by minimum experience requirements
May distort the efficient allocation of people and jobs
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Subjective Evaluations
- Other public goods
Copy machine
Free good: too much copying
Solution: password
Telephones, materials, and anything else considered to be a free good
Allocated through a market transaction
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Business Insight
Motivation
- Experimental evidence
People often act contrary to their material self-interest
People will forgo some income or wealth
To ensure what they consider a fair outcome
To choose what they perceive as the moral or ethical direction
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Business Insight
Motivation
- Some people possess a work ethic
Choose to do good work for its own sake
Intrinsically motivated
Lower quality of work – if monitoring or pay for performance incentive schemes
- Research - external rewards
Disrupt intrinsic motivation
Boost intrinsic motivation
Or have no effect whatsoever
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Externalities
- Unethical actions
Impose externalities on the other stakeholders of the firm
- Solution – internalize the externality
Increase monitoring
Assignment of property rights
Employees - privately arrange many solutions to potential externalities
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Principal-Agent Problems
- Different objectives, conflicting incentives
Owners – increase value of the firm
Managers – greater compensation, more benefits, better perquisites
Employees – high pay and benefits, job stability, and lots of leisure time
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Principal-Agent Problems
- Principal-agent relationship
One individual acts on behalf of another individual
The principal - the individual wanting some task undertaken or some result carried out
The agent - the individual who carries out the action on behalf of the principal
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Principal-Agent Problems
- Principal-agent relationship
CEO of a publicly held firm
The agent of the shareholders
Hired manager of a private firm
The agent of the owner or owners
Employees - the agents of the CEO or manager
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Principal-Agent Problems
- Principal-agent problem
The principal and agent may have different interests
- Solution
The principal - must create the incentives that will align the agent’s interests with his or her own
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Moral Hazard and Risk-Sharing
- Firms and their employees
Subject to risks
Pay may fluctuate; profits may fluctuate
People may be laid off
Firms may go bankrupt
- Risk-sharing
Aggregate cost of bearing risk is lower
When two or more individuals share that risk
Than when each bears the risk individually
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Moral Hazard and Risk-Sharing
- Insurance - risk-sharing
Spread risks widely
Reduce the risks of individual policyholders
- Firm
Must provide insurance to the individual who takes on the extra risk
- Moral hazard
Once the individual has insurance – change behavior
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Moral Hazard and Risk-Sharing
- Minimize moral hazard
Insurance contracts
Co-payments and deductibles
Firms
Compensation schemes
Agreed-upon contract and bonus
Personnel policies
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Monopoly: Hold-up Problems
- Adverse selection
Some persons know more about the current condition and future prospects of the firm than outside investors
- Mechanisms to control the problem of adverse selection
Financial reporting - credibly converting inside information into outside information
Analysts – monitor the financial conditions of firms
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Monopoly: Hold-up Problems
- Difficult to acquire information
Those who have the information - act as a monopolist
Provide the information only at a high price
Holding up the firm
- Relationship-specific assets
Asset that can be used in just one situation
Increased chance of hold-up
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Monopoly: Hold-up Problems
- Solution to monopoly problems:
Competition
Firm: substitutes available to the company for the person or the division attempting to hold the firm
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Monopoly: Hold-up Problems
- Second sourcing
Patent holders
Produce a new product innovation themselves
License the rights to sell the product to another manufacturer
Innovator - induces others to commit themselves to the innovation
Create complementary investments that enhance the innovation’s value
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Compensation Arrangements
- Compensation and personnel policies
Must enhance the efficiency of the firm
Minimize some market failures
Increase efficiency
Direct incentives and guide behaviors
Skill
Idiosyncratic factors
Specific kinds of workers
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Efficiency Wage
- Efficiency wage
Wage paid to the employee exceeds the market wage
To attract higher-quality employees
Costs to the employee of getting dismissed are higher
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Backloaded Compensation
- Backloaded compensation
Rising wage profile
Compensation increases with time on the job
Compensation is higher as the years on the job increase
Eventually exceeds the contributions the employee makes to the firm
Incentive for an employee to remain with a firm and perform well
Reduce employee turnover
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Figure 6.1
The longer a person is employed by a firm, the higher is his or her pay. Initially, pay is less than the person’s value to the firm but eventually compensation exceeds the person’s value to the firm.
Backloaded Compensation
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Figure 6.2
Initially compensation is less than productivity, but eventually compensation is greater than productivity. This pattern ensures that the employee has an incentive to stay with the firm.
Backloaded Wages
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Downsizing
- Downsizing
Reduce firm’s labor force
- Firms with backloaded compensation and a steep wage–productivity profile
Unlikely to downsize
Have to maintain a reputation for retaining employees
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New Blood
- New blood
Firm wants to induce turnover
Enables firms to
Stay abreast of what the other companies are doing
Benefit from new ideas and approaches
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New Blood
- Wage compression
Relatively flat compensation profile
New employees are brought in
Compensation levels - match or exceed the compensation of employees who have been with the firm for a number of years
The only way that an employee could receive large increases in pay: change companies
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Piece-Rate Compensation
- Piece-rate pay scheme
Compensates employees for how much each produces
Needs: relatively easy to measure individual contributions to firm value
Higher productivity
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Piece-Rate Compensation
- Disadvantages
Difficult to measure the productivity of individual employees
Can create incorrect incentives
Lower quality
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Tournaments
- Tournaments
Hierarchy
Reward competence and performance
Increase authority
Promotion and pay increases go hand in hand
More productive behavior
The more competent gain more authority
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