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Game Theory Topic 7 Information “I like work. It fascinates me. I can sit and look at it for hours.” - Jerome Klapka Jerome
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The Simpsons on Incentive Pay “If you don't like your job, you don't strike. You just go in every day and do it really half-assed. That's the American way.” Mike Shor 2
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The Simpsons on Incentive Pay “Behold, the greatest breakthrough in labor relations since the cat o' nine tails!” Mike Shor 3
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Incentive Schemes Salary and bonus contracts can compensate for information asymmetry Often, this is unreasonable Employees unwilling to assume risks Contracts must be perfectly balanced May be better to settle for low effort Employee Perceptions Leakages Group Rewards Mike Shor 4
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A Horrible Disease A new test has been invented for a horrible, painful, terminal disease The disease is rare One in a million people are infected The test is accurate 95% correct, 5% false positive/negative You test positive! How worried are you? Mike Shor 5
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Bayes Rule What is the chance that you have the disease if you tested positive? Mike Shor 6
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Leakages IBM Variable Pay Bonus of 10% of annual earnings if “annual objectives are met in key areas” Internal Memo: “We observe, across divisions, performance in line with expectations through about March. Performance declines consistently in later months.” Mike Shor 7
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Leakages If bonus is tied to Increases over last year Reduce this year’s growth Output / Quantity Reduce quality Average customer satisfaction Reduce number of service calls Mike Shor 8
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Strategic Considerations If bonus is tied to … Market share Firm profits Industry profits Mike Shor 9
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Example Pharmaceutical Development
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Goal: Align Research Labs’ Incentives “Strong resource devotion to select projects marginally increases the chance of success, but when considering the potential profitability of the post-patent market, it is clear that proper incentive alignment is essential.” Mike Shor 11
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Market Conditions Patent races over high-profit pharmaceuticals worth up to $2 billion Resource devotion ranges from twenty to sixty hours per employee, with staff of fifty per project (low level to high level) Project time frame: 6 months Mike Shor 12
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Market Conditions Independent labs contracted Average cost of labor: $16/hour Chance of success: Minimally:1% Maximally:2.5% Mike Shor 13
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Cost Calculations Extra cost to lab of high effort: 40 hours / week / employee x25 weeks time frame x $16 / hour _ = $16,000 / employee Mike Shor 14
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To entice high effort Costs: $16,000 per employee in costs Benefits: 1½% extra chance of success (2½% - 1%) Incentive compatibility:.015 x bonus > $16,000 bonus > $1.1M Mike Shor 15
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To entice high effort Bonus per employee must be greater than $1.1 million Fifty employees, so total bonus must be greater than $55 million Final conclusion $75 million bonus “to be safe” Mike Shor 16
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Extra Profit if it Works Value of extra chance of success: 0.015 x $2B = $30M Cost of bonus: 0.025 x $75M = $2M Benefit of plan: $30M – $2M = $28M Mike Shor 17
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Problem Ignoring individual incentives Analysis assuming that entire group works hard or does not Quick & Dirty Check: If fifty people working hard increases chance of success by 1.5%, each person, on average, increases chance by only 1.5%/50 = 0.03% Each person earns a bonus of $75M/50 = $1.5M Mike Shor 18
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Conclusion A person’s value of extra time: $1.5M x 0.03% = $450 A person’s cost of extra time: $16,000 NOT EVEN CLOSE! Mike Shor 19
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Summary Enticing high effort is hard work Leakages Global vs. individual incentives Rewarding the right people But often worth it if you can do it right Mike Shor 20
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