ECON3430:
Managerial Economics
Week 1: Incentives and games
Dr. Kenan Kalaycı
CRICOS code 00025B
Lesson 1-2 objectives
2
Answer the question:
How should organisations motivate their employees
to get the best possible results?
…using insights from
1.Behavioural game theory
2.Behavioural principal-agent theory
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What did you want to be when you
were growing up?
https://www.youtube.com/watch?v=lxRwEPvL-mQ
3
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Incentives
• Why do people do what they do?
• Factors that affect human behaviour
- Material/financial incentives
- Information
- Societal norms
- Habits, interests, values, emotions…
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Incentive problems
• Employees who want to minimise effort
• Employees who don’t do what the manager wants
them to do
• Team members who don’t want their effort ruined by
others in the team
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Game 1
6
Player 2
Action A Action B
Player 1 Action A $3, $3 $0, $5
Action B $5, $0 $1, $1
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Game Theory
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Game theory - a set of tools that economists, political scientists,
military analysts and others use to analyze decision making by
players who use strategies.
• very important tool for the analysis of negotiations within and
between firms
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Common knowledge
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Common knowledge
– a piece of information known by all players, that is
known to be known by all players, and so forth.
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Rationality
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Implicit assumptions about rationality in game theory:
1. Individuals have the cognitive ability to weight all their options and
make a choice according to their preferences (i.e. perfect
rationality).
2. In experimental games payoffs are interpreted to be utilities and
that participants prefer a higher payoff over a lower payoff (selfish
preferences).
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Common knowledge of rationality
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Common knowledge of rationality:
• I am rational. You are rational.
• I know that you are rational. You know that I am rational.
• I know that you know that I am rational. You know that I know that
you are rational.
• I know that you know that I know that you are rational. You know
that I know that you know that I am rational.
• And so forth, ad infinitum.
• http://www.youtube.com/watch?v=TmMna1EwZ1E
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Best Response and Nash Equilibrium
11
Best response - the strategy that maximizes a player’s payoff given
its beliefs about its rivals’ strategies.
Nash equilibrium - a set of strategies such that, when all other
players use these strategies, no player can obtain a higher payoff by
choosing a different strategy.
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Prisoner’s Dilemma
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Player 2
Action A Action B
Player 1 Action A $3, $3 $0, $5
Action B $5, $0 $1, $1
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Game 2
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Player 2
Action A Action B
Player 1 Action A $4, $4 $1, $3
Action B $3, $1 $2, $2
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Team production
14
Teams can be time consuming to organize and coordinate.
Teams suffer from the free-rider problem:
• that lazy individuals might free-ride on the effort of a few team
members.
So why do firms use teams?
Lazear, E.P. and Shaw, K.L., 2007. Personnel economics: The economist's view of human resources. Journal of
economic perspectives, 21(4), pp.91-114.
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Team production
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• Many projects require multiple skills that single
individuals don’t posses.
- If there are complementarities between the skills of
different workers team production can be more
productive than individuals working alone.
Lazear, E.P. and Shaw, K.L., 2007. Personnel economics: The economist's view of human resources. Journal of
economic perspectives, 21(4), pp.91-114.
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Team production
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• If generalists are more expensive, because they are rare,
firms will choose teams.
• In new technologies, rapid evolution of information makes it
difficult for any one person to have an absolute advantage in
everything
• Teamwork requires communication, which can involve both
common jargon and personal knowledge of each other.
- Psychological safety is crucial for effective communication.
Lazear, E.P. and Shaw, K.L., 2007. Personnel economics: The economist's view of human resources. Journal of
economic perspectives, 21(4), pp.91-114.
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• Teams face coordination problems
• Coordination problems may be solved via
- Communication
- Repeated interaction
- Hiring cooperative types (e.g. no jerks policy)
- Modifying the incentives
Team Work
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Minimum effort game vs. Prisoner’s
Dilemma vs Harmony game
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Player 2
Action A Action B
Player 1 Action A a, a c, b
Action B b, c d, d > > > → - > > > → ! - > > > →
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Player 2
High Effort Low Effort
Player 1 High Effort a, a 1, b
Low Effort b, 1 2, 2
Modifying the incentives
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Ernesto Dal Bó, Pedro Dal Bó, Erik Eyster, The Demand for Bad Policy when Voters Underappreciate Equilibrium Effects,
The Review of Economic Studies, Volume 85, Issue 2, April 2018, Pages 964–998,
https://doi.org/10.1093/restud/rdx031
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• Monetary incentives increase performance in routine tasks such as fruit picking, tea
plucking, tree planting, sales, or production (see, e.g., Bandiera et al., 2005, 2013;
Delfgaauw et al., 2015)
• Can the efficacy of incentives substantially differ in non-routine analytical team tasks?
- crowding out workers’ intrinsic motivation
- output could be a noisier function of effort
- free-riding could be present in team settings
- salient incentives may alter team organization
The Effect of Incentives in Non-Routine Analytical
Team Tasks
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Englmaier, F., Grimm, S., Grothe, D., Schindler, D., & Schudy, S. (2024). The Effect of Incentives in Non-Routine
Analytical Team Tasks. https://doi.org/10.1086/729443
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• Englmaier et al., (forthcoming, JPE) study the performance of teams in a real-life escape
game study the performance of teams in a real-life escape game
- Treatment: a team bonus (of 10 Euros per participant) if the team completed the task
within 45 minutes (the regular upper limit for completing the task was 60 minutes).
- Control condition: no incentives
• They find that bonus incentives increase performance.
- Teams in the incentive treatment are more than twice as likely to complete the task within
45 minutes.
- increased demand for leadership among treated teams
The Effect of Incentives in Non-Routine Analytical Team
Tasks
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Englmaier, F., Grimm, S., Grothe, D., Schindler, D., & Schudy, S. (2024). The Effect of Incentives in Non-Routine
Analytical Team Tasks. https://doi.org/10.1086/729443
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Two player, sequential move game between Player A and Player B.
If the day of your birthday (i.e. Aug 7th) is an odd number you are Player A,
otherwise (i.e. Aug 6th) you are Player B.
• Player A is given $10 and makes an offer “S” to Player B, where S ∈ [ 1,2..,9]
- Hence Player B gets $S and the Player A keeps the rest (10-S ) .
- i.e. Give $1 keep $9, give $9 keep $1, give $5 keep $5 etc.
• If Player B accepts the offer, Player B gets $S and Player A gets $(10-S).
• If Player B rejects the offer they both get $0
Game 3
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If the day of your birthday (i.e. Aug 7th) is an odd number you are
Player A, otherwise (i.e. Aug 6th) you are Player B.
• If you are Player A choose the amount S you offer to Player B .
• If you are a Player B choose the minimum amount S you would
accept.
• After everyone makes their decisions I will randomly pick a Player
A and a Player B. I will ask Player A to allocate $10 according to
their choices.
Game 3
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Two-player game: Proposer and Responder
Proposer is endowed with a fixed amount ($10)
Makes an offer ($10 - offer, offer) to Responder
If Responder accepts, Responder gets offer and Proposer gets $10
- offer.
If Responder rejects they both get 0
Unique subgame perfect equilibrium is:
for Responder to accept any (non-negative) offer and for Proposer
to make the minimum offer possible
Ultimatum game
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Common findings:
• There are virtually no offers above $5.
• The vast majority of offers in almost any study is in the interval
[$4, $5].
• There are almost no offers below $2.
• Low offers are frequently rejected, and the probability of rejection
tends to decrease with the offer.
Ultimatum game
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Social preferences
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What is fair?
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Pay compression
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In the last three decades variance of pay across workers has risen:
• within and across occupations, within and across firms.
• mainly because the upper tail of high earners has grown
• due to shifts towards pay-for-performance and growth in firm sizes
Unequal pay can demoralise workers who are paid less than their co-
workers who are “just like them”. People value equity or fairness in pay.
Compressing pay (relative to output);
• can increase morale and worker efficiency (esp. in teams)
• but might lead to high-productivity workers to leave the firm.
Lazear, E.P. and Shaw, K.L., 2007. Personnel economics: The economist's view of human resources. Journal of
economic perspectives, 21(4), pp.91-114.
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The Morale Effects of Pay Inequality
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• Breza et al., (2018) conduct a month-long experiment with Indian
manufacturing workers.
• They randomize whether co-workers within production units receive the
same flat daily wage or differential wages according to their (baseline)
productivity ranks.
• When co-workers' productivity is difficult to observe, pay inequality reduces
output by 0.45 standard deviations and attendance by 18 percentage points.
• However, when workers can clearly perceive that their higher-paid peers are
more productive than themselves, pay disparity does not affect output,
attendance, or group cohesion.
Breza, E., Kaur, S., & Shamdasani, Y. (2018). The Morale Effects of Pay Inequality. The Quarterly Journal of Economics,
133(2), 611-663. https://doi.org/10.1093/qje/qjx041
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When should we (not) use standard game theory?
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Takeaways
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Game theory is useful in understanding interactions within a firm
• Many situations can be simplified and analysed as a well-studied
standard game
• Caveat: Assumptions about rationality and common knowledge of
rationality, may not always hold.
• Behavioural game theory:
- Takes into account “levels of rationality”, social norms, social
preferences, beliefs, cognitive limitations, cost of errors, …
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Next lecture
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Incentive conflicts (principal-agent theory) and organisation of the
firm.
Dr. Kenan Kalaycı | Senior Lecturer
School of Economics
k.kalayci@uq.edu.au
kenankalayci.com
twitter.com/kalayci_kenan
Questions?