1. Chapter 21: Getting Employees to Work in the Firm’s Best Interest
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Managerial Economics: A Problem Solving Appraoch (2nd Edition)
Luke M. Froeb,
Brian T. McCann,
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Slides prepared by Lily Alberts for Professor Froeb

2. Summary of main points
Principals want agents to work for their (the principals’) best interests, but agents typically have different goals than do principals. This is called incentive conflict.
Incentive conflict leads to adverse selection (“which agent do I hire?”) and moral hazard (“how do I motivate agents?”) when agents have better information than principals.
Three approaches to controlling incentive conflict are
Fixed payment and monitoring (shirking, adverse selection, and monitoring costs),
incentive pay and no monitoring (must compensate agents for bearing risk with a risk premium), or
sharing contracts and some monitoring (some shirking and some risk sharing which leads to lower risk premium).

3. Summary of main points (cont.)
In a well-run organization, decision makers have
(1) the information necessary to make good decisions and
(2) the incentive to do so.
If you decentralize decision-making authority, you should strengthen incentive compensation schemes.
If you centralize decision-making authority, you should make sure to transfer specific knowledge (information) to the decision makers.

4. Summary of main points (cont.)
To analyze principal–agent conflicts, focus on three questions:
Who is making the (bad) decisions?
Does the employee have enough information to make good decisions?
Does the employee have the incentive (performance evaluation + reward system) to make good decisions?
Alternatives for controlling principal–agent conflicts center on one of the following:
Reassigning decision rights (to someone with better incentives or information)
Transferring information
Changing incentives (performance eval. + reward system)

5. Introductory anecdote: ASI
Auction Service International (ASI) employed art experts to convince owners of valuable art to use auction services to sell their artwork.
The auction house profited by charging the art owners a percentage of the sell price at auction.
This percentage was negotiated by the young art experts.
A problem arose, the negotiated prices (“commissions” to the auction house), which were supposed to be between 10 and 30%, were consistently low, near 10%.
The CEO of ASI began investigating this phenomenon and found that the art experts were “trading” low prices for kickbacks from the art owner.
Discussion: What are two possible solutions for this problem?
Solutions: Transfer info to centralized decision-maker and let him or her make decisions on rates or change incentives of experts
The CEO of ASI took away the experts’ discretion to negotiate the rates. This action ended the exchange of gifts for lower rates, but the experts had become accustomed to the kickbacks, considering them an important part of their compensation package. Many of the art experts quit, leaving to set up their own independent galleries in direct competition with ASI.
To make matters worse, the CEO decided to set a 17% rate by conspiring with a rival auction house. When the conspiracy was discovered, the CEO was sentenced to a year in jail, and the judge tacked on a $7.5 million fine, an amount calculated as 5% of the $150 million volume of commerce affected by the price-fixing conspiracy.

6. Principal-Agent Relationships
When studying firm-employee relationships we use principal-agent models.
Definition: A principal wants an agent to act on her behalf. But agents often have different goals and preferences than do principals.
The auction house is a principal; the art expert is an agent.
Note: for convenience only, we adopt the linguistic convention of referring to principals as female and agents as male.

7. Incentive Conflict
Because the agent has different incentives than the principal, the principal must manage the incentive conflict, which comes down to two problems with which you should by now be familiar:
Adverse selection: the principal has to decide which agent to hire
Moral hazard: once hired, the principal must find a way to motivate the agent.
Both problems are caused by asymmetric information: adverse selection implies that only the agent knows his “type”; while moral hazard means that only the agent knows how much effort he is exerting.
The costs of addressing moral hazard and adverse selection are known as agency costs, because they are often analyzed by principal-agent models.

8. Agency Costs Information gathering:
A principal can reduce agency costs if she gathers information (reduces information asymmetry)
about the agent’s type (adverse selection); or
about the agent’s actions (moral hazard).
Information gathering:
To mitigate adverse selection problems, firms can run background checks on agents before they are hired.
To mitigate moral hazard problems, firms can monitor an agent’s behavior while working.
This difference in timing leads to the characterization that adverse selection is a pre-contractual problem, while moral hazard is a post-contractual problem.
For ASI: A better solution would have been to leave the rate-setting authority with the art experts but change to an incentive compensation scheme—for example, one that paid art experts a percentage of the revenue they bring to the firm.
This kind of compensation scheme better aligns the agents’ incentives with the firm’s goals. If the agents set profitable rates, they’ll increase both the firm’s profit and their own compensation.

9. Incentive Pay vs. Risk
Incentive pay can help align the incentives of employees (agents) with the goals of the organization (principal).
For example, if harder work leads to higher sales, then create incentives by tying the employee’s reward to sales performance, e.g., with a sales commission.
But incentive pay also imposes risk on agents.
Commissions mean a portion of an agent’s compensation is dependent on factors beyond the agent’s control, e.g., weather.
Agents must be compensated for taking on this additional risk.
So, incentive compensation represents a tradeoff:
Does the benefit (harder work by agent) outweigh the cost (extra compensation for bearing risk)?

10. Controlling incentive conflict
In an ideal organization
Decision-makers have all the information necessary to make profitable decisions; and
The incentive to do so.
When designing an organization, you should consider how to structure the following three items.
Decision rights: who should make the decisions?
Information: is the decision-maker provided with enough information to make a good decision?
Incentives: does the decision-maker have the incentive to do so. Incentives are created by linking performance evaluation and reward systems (rewarding good performance).

11. Decision Rights and Information
Who should make decisions?
Decentralize decision making: move decision rights down in the hierarchy, closer to those with better information; or
Centralize decision making: move decision rights up in the hierarchy, closer to those with better incentives.
If you decentralize decision-making authority, you should also strengthen incentive-compensation schemes.
If you centralize decision-making, find a way to transfer information to those making decisions.

12. Incentives (performance + reward)
Performance evaluation
Informal: using subjective performance evaluation, or
Formal: using objective measures such as sales or accounting profit, stock price, relative performance metrics.
Rewards: Decide how compensation is tied to performance evaluation.
Reward good performance and/or penalize bad performance.
Examples: bonus, increased probability of promotion, faster promotion.
Example: a fruit farmer trying to decide how to pay pickers.
One option is to pay workers a piece rate based on the number of pieces picked.
A complicating factor is that the rate has to be increased when pickings are slim to ensure that the workers earn the minimum wage required by law.
Under this system, workers monitor each other to discourage fast picking, resulting in the piece rate being raised. This defeats the point of the incentive compensation scheme.
One solution is to have managers test-pick a field to gauge the difficulty of picking and then set the piece rate based on the results of the test-pick.
The lesson of this story is to realize that workers have an incentive to “game” compensation schemes. First, try to anticipate the more obvious games and adjust the compensation scheme to prevent them. Second, monitor outcomes to ensure that you are getting the behaviors you really want.

13. Example: Marketing vs. Sales
Sales and marketing divisions often have incentive conflict
Sales wants to maximize revenue, i.e., make all sales where MR > 0
Marketing wants to maximize profit, i.e., make all sales where MR > MC.
In other words, sales prefers a higher level of sales and a lower price than does marketing.
For example, a large telecommunications equipment company that serves government agencies that buys telecom equipment.
Sales people want to bid more aggressively to make sure that they win the contract (they care about maximizing sales)
Marketing wants the sales agents to bid less aggressively, so that when they do win, the contracts are more profitable (they care about maximizing profit).
The incentive conflict arises because marketing managers receive stock options or profitability bonuses as compensation, whereas salespeople receive commissions based on revenue.
Marketing wants to maximize profitability, so wants sales where MR > MC.
Sales merely wants to maximize revenue, so wants any sale where MR > 0 (meaning sales people simply want more sales, or lower prices)
Another solution is to require sales agents to obtain permission to reduce price below some specific threshold. To obtain permission to reduce price, sales agents would have to provide their supervisors with evidence that the price reduction is necessary.
If done well, this solution can ensure that enough information is transferred to the marketing manager so that she can prevent sales agents’ making unprofitable price reductions.

14. Marketing vs. Sales (cont.)
Two solutions:
Centralize bidding decisions to marketing; and try to transfer enough information to marketing managers so they know how aggressively to bid.
Decentralize bidding decisions (keep decision rights with the sales people) and change incentives – Instead of a 10% commission on revenue, give sales people a 20% commission on profit, (revenue neutral if the contribution margin is 50%)
Discussion: How well do threshold compensation schemes work, e.g., a bonus if you open hit a target sales number.
Discussion: How well do high-powered sales commissions work, e.g., 5% commission for sales of $1M; 10% commission on sales of $2M, work?
The incentive conflict arises because marketing managers receive stock options or profitability bonuses as compensation, whereas salespeople receive commissions based on revenue.
Marketing wants to maximize profitability, so wants sales where MR > MC.
Sales merely wants to maximize revenue, so wants any sale where MR > 0 (meaning sales people simply want more sales, or lower prices)
Another solution is to require sales agents to obtain permission to reduce price below some specific threshold. To obtain permission to reduce price, sales agents would have to provide their supervisors with evidence that the price reduction is necessary.
If done well, this solution can ensure that enough information is transferred to the marketing manager so that she can prevent sales agents’ making unprofitable price reductions.

15. Example: Franchising
Incentive conflict exists between franchisors (McDonalds) and its franchisees. McDonalds wants big franchise fees and high quality at franchisees to protect its reputation. Franchisees want smaller fees and lower quality (cheaper).
McDonalds has both company owned stores and franchisees.
In a company-owned store, both adverse selection and moral hazard are concerns – managers don’t work as hard as they would if they owned the restaurant, and a salaried manager position might attract lazy workers.
Franchisees have bigger incentive to work hard (because they are the “residual claimants” of profit), but they are also exposed to more risk. Franchisees have to be compensated (lower franchise fees) for bearing risk.

16. Franchising (cont.)
Another option is to use a sharing contract: instead of a fixed franchise fee, the franchisor might demand a percentage of the revenue or profit of the restaurant.
This arrangement reduces franchisee risk by reducing the amount the franchisee pays to the franchisor when the store does poorly.
Sharing contracts may also encourage shirking because the franchisee no longer keeps every dollar he earns.
DISCUSSION: Why does McDonalds use company- owned stores along freeways, but franchises in towns?

17. Diagnosing and solving problems
To analyze principal-agent problems, begin with the bad decision that is causing the problem, and then ask three questions.
Who is making the (bad) decision?
Did agent have enough information to make a good decision?
Did agent have the incentive to do so, i.e., how is the employee evaluated and compensated?
Answers to these questions generally suggest alternatives for reducing agency costs. You can,
Let someone else make the decision, or
Change the information flow, or
Change the incentives.
For the ASI example:
Who is making the bad decision? The art experts. They were negotiating rates that were too low.
Did the decision makers have enough information to make good decisions? Yes—in fact, they were the only ones with enough information to set profitable rates.
Did the decision makers have the incentive to make good decisions? No. The art experts received a flat salary, making it relatively easy for art owners to bribe them with gifts.

18. Example: Declining Store Profits
The CEO of a large retail chain of “general stores” that target low-income customers has noticed that newly opened stores are not meeting sales projections.
What is the problem here? And how can it be fixed?
Some helpful information about the stores is,
The company uses development agents to find new store locations and negotiate the leases with property owners – the company rewards these agents with generous bonuses (stock options) if they open fifty new stores in a single year.
Agents are supposed to open new stores only if their sales potential is at least one million dollars per year, but recently opened stores earn half this much.
What is the problem; and what is the solution?
Who is making the bad decision? The development agents were opening unprofitable stores.
Did they have enough information to make a good decision? The development agents had good information about whether the new stores would be profitable.
Did they have the incentive to do so? No. The agents were rewarded for opening fifty stores each year, regardless of their profitability.
Solutions:
(Decentralization) The company could change the incentives of the development agents by rewarding them for opening only profitable stores.
(Centralization) Alternatively, the company could oversee the decision to open stores from agents and then gather its own information about the potential profitability of new store sites.

19. Alternate Intro Anecdote
Whaling ventures in the 1800s were managed by agents, who would purchase supplies, hire a captain and crew, and plan the voyage on behalf of the investors.
Agent’s performance difficult for investors to observe or evaluate
Actions of crew on multi-year voyages even more difficult to evaluate
Contracts and organizational forms century evolved in response to these problems
Most whaling enterprises were closely held by a small number of local investors
Ownership rights were allocated to create powerful incentives for their managers
Agents usually held substantial ownership shares in their ventures
Incentives in Corporations: Evidence from the American Whaling Industry
Eric Hilt
NBER Working Paper No
March 2004
JEL No. N5, L2, G3

20. Alternate Intro Anecdote (cont.)
Attempting to run these ventures via corporation form in the 1830s and 1840s failed
They paid their crews the same ways, used similar vessels, and employed agents with similar responsibilities
Only main difference was in ownership structures and hierarchical governance
They were unable to create the incentives requisite for success in the industry. The managers of these corporations, who did not hold significant ownership stakes, did not perform as well as their peers in unincorporated ventures.

21. Managerial Economics - Table of contents
1. Introduction: What this book is about
2. The one lesson of business
Benefits, costs and decisions
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
The problem of adverse selection
The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
Managerial Economics - Table of contents