Hierarchies, incentives and firm structure ECOS3003
Tutorial 7
1. Performance measurement and incentive schemes are jointly determined. Comment.
Performance measurement – increases the accuracy of measuring effort; the more accurate, the less risk
faced by the agent.
This relates to incentive schemes because there is a trade off between costs of making agent bear more risk
and the costs of imposing measurement.
2. “One problem with incentive schemes is they motivate too much, rather than not enough”.
Comment.
In the multi-task principal-agent problem, the P wants a balance between tasks. Hence, incentives can be
too strong if individual only focuses on task included in incentive contract (don’t get a balance between
tasks)
3. Question 16-2 on page 515.
Compensation package sensitive to exogenous factors, so increases the risks that Kraft has to bear – and if
she is risk averse this increase the cost of her remuneration package in expected terms.
But, it could still be desirable for the firm to include these exogenous factors into Kraft’s contract, because
Kraft could reduce the impact of these events on the company by (for example): hedging against gold price;
buying earthquake insurance; and after the event ensuring quick repairs. If Kraft knows she is not response,
she has less incentive to decrease the cost of exogenous events.
Further, if the company alters the compensation package, there could be an issue with influence costs: it
increases the incentive for Kraft and other managers to spend effort explaining why events are
uncontrollable.
4. Question 16-14 on page 518
Good tree thinning involves quality and quantity; paying by the tree emphasises quantity. Also, it is
difficult to observe quality after the fact.
5. Consider a team of three workers. Total output, O, is given by O = 10e1 + 12 e2 + 4e3, where ei is
the effort level of worker 1, 2, or 3. The effort costs of each worker are given by ei2.
(a) What is the first best level of effort for each worker?
e1* = 5; e2* = 6; e3* = 2
(b) Now suppose that each worker’s effort level cannot be verified by a court. The firm has to
distribute all of the output to the worker (ie O – w1 – w2 – w3 = 0). First, the firm implements the
sharing rules that each worker gets one third of total output. What will be the effort levels of each
worker in this case? How does your answer differ from your answer in (a) and why?
For example, worker 1 now maximises U1 = 1/3(10e1 + 12 e2 + 4e3) – e12. Differentiate and set equal to
zero and you get
2
10/3 – 2e1 = 0
e1 = 5/3; e2 = 2; e3 = 2/3
The difference is because the externality: each worker does not receive the full MB from an increase in
effort but they incur the full MC.
(c) What about the sharing rule when worker 1 gets 10/26 of the output, worker 2 gets 12/26 of the
output and worker 3 gets 4/26 of the total output? If this rule does not get the first best, suggest one
that does?
e1 = 25/13; e2 = 36/13; e3 = 4/13
(d) How can this team overcome this moral hazard in teams problem?
need to give the full MB from effort to each worker, ie
wi = 10e1 + 12e2 + 4e3 for i = 1,2, 3
(this means the balanced budget constraint is broken)
Alternatively, improvement measurement so can measure individual effort, not just team effort.
6. The simple principal/agent model assumes:
a. the principal does not know the employee’s production function
b. the principal cannot observe effort, random factors and output
c output can be measured at zero cost
d. all of the above
e. none of the above
7. Question 16-6 in the text
Piece rates encourage employees to focus on quantity of output.
the output of the employee should be sensitive to the employee’s effort and not subject to large random
fluctuations.
Piece rates do not provide incentives for team work, generating ideas, training new employees etc; if these
are important, should not use piece rates or pay additional incentives to encourage these activities.
The piece rate should reflect market-determined wage rates. the company will probably want to change
piece rates when technology changes that causes the rate of output of change.
The company should realise that if it changes the piece rate because it is “overpaying” employees, that
employees will come to anticipate these changes and will have incentives to collude to restrict output
(ratchet effect)
8. What do you think caused the shift to the very lucrative incentive contracts in more recent times?
Bebchuk and Fried 2003 suggest that contract for executives do not reflect the result of arms length
bargaining between management and company boards; rather, the form and level of executive pay (rent
extraction) reflects management’s power in this process. This managerial power hypothesis suggests that
pay will be higher and less sensitive to performance in firms in which managers have relatively more
power, for example when:
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The board is relatively weak (many insiders on the board)
There is no large outside shareholder
There are fewer institutional shareholders
Managers are protected by anti-taker arrangements
According Bebchuk and Fried, executives use stock option as a way to camouflage their rent extraction
from external scrutiny. They argue that the managerial power hypothesis also explains why exercise prices
are set at grant-date market prices, why they are not indexed to general market movements (ie do not use
relative performance measures) and are often reset following market declines.
Given the recent growth of executive pay, this would be consistent with the managerial hypothesis if the
above factors shifting to allow for greater managerial power. Hall and Murphy (2003) argue that this has
not been the case. They argue that board has become more independent, for example. They argue that stock
option have been used because the perceived cost of stock options is lower than the economic cost – issuing
a stock option has the cost of what outside investors would pay for the option, but it bears not accounting
charge or outlay. And when the option is exercised, the company typically issues a new share to the
executive and receives a tax deduction for the spread between the stock price and the exercise price. While
accounting rules may provide an incentive for stock options, it does not explain why executives have
received option in addition to the packages previously received (rather than a substitution).
In all, this is still an open question, with researchers holding different view points.
9. “Modern day incentive schemes have failed shareholders and non-executive employees badly.”
Discuss this statement with reference to Holden (2005) and reference to the incentive schemes of Du
Pont and General Motors in the fist half of the 20th century.
The shareholders would like executives to maximise the value of the firm. Given their different structure
old incentive schemes (Du Pont and GM) provide different incentives to executives than the new schemes.
The main differences are that: the old schemes incorporate a cost to the executive for poor performance; the
old schemes are longer in horizon; the old schemes applied to many more employees in the organization
than the new schemes.
New incentive schemes are based on stock options. Stock options reward an executive for a high share
price. However, if the share price falls below the option asking price there is no cost or downside to the
executive – she will simply opt not to exercise the option. This provides skewed incentives to the executive,
increasing their expected return from a risky project (unlike the shareholder who still bears the cost of an
unsuccessful outcome).
Old schemes, on the other hand, involved a cost (or “hurt money”) if the share price fell. At Du Pont,
executives were required to invest in interesting bearing notes that were secured by stock in the company.
If the value of the stock fell, the notes would not be adequately secured and the executive would be
required to provide further security – stock price falls had a real cost to the executive. Also note that notes
could only be paid down by dividends and bonuses, providing a strong disincentive for the over retention of
earning.
Second, stock options today are typically of a short duration – like one or two years. This gives the
executives today an incentive to boost present profits or the image of the company, even if it costs the
company in the long run. Further, there is less incentive to make long term investments. Old schemes often
were much longer in duration – like 7 or 10 years. This provided the executives an incentive to maximise
firm value in the long term.
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Third, the old schemes were relatively large in size – at Du Pont the average purchase of shares by an
executive was $152 000 (in 1930 dollars), while the highest paid executive in the firm earned less than
$100 000. At GM the share purchase was $223 000 per participating executive, which translates to $2.3
million per executive in 2004 dollars. The size of investment by executives clearly creates a strong
incentive to perform – it goes a long way to aligning the interest of the executives with shareholders.