# Principal-Agent Problem Arises when an agent (employee) is acting on behalf of a principal (firm or firm's owner), but has alternate incentives. ### Examples - Principal: Maximize firm value - Agent: Disutility of Effort #TODO #### Taxi Drivers Example Options shown with Taxi Drivers. Two options: 1. Driver rents cab from company for fixed amount, and driver keeps all excess 2. Driver and cab company split revenue 50/50 ##### Option 1: - Shifts risk to driver - Driver faces more upside - Company faces less upside - Driver has significant incentives to maximize revenue ##### Option 2 - Risk is carried by both driver and company - Driver faces less upside (Compared to Option 1) - Company faces more upside (Compared to Option 1) - Driver has limited incentive to maximize revenue, because the cab company takes 50% ##### Notes Option 1 is generally a better option. Option 2 presents the drivers with issues like: > Consider a taxi driver who has been working for 8 hours and is trying to decide whether to drive for another hour. > Option 1: Earn $x$ amount for the additional hour > Option 2: Earn $\frac x2$ amount for the additional hour Option 1 also faces benefits - Less monitoring cost (does not need to worry about driving without a customer, as the company bears no cost in this) - Elicit more effort (Greater incentives) - Attract hard-working drivers (Those who want to put in extra effort to earn more have greater incentives with this option) - Be able to charge higher rental fee - Shift risks to the driver --- # Designing Incentive Compensation ## Strength of Incentives >[!question] How strong should incentives be? When considering the **strength** of incentives, the **slope** is what matters. Jobs with larger incentives tend to have higher total pay. - Employees are motivated to work harder - Stronger incentives attract more productive employees with higher market values - Selection bias - Employees must be paid a higher risk premium - Upside for high-risk incentives must be extremely high to outweigh the expected value of lower-risk options. ## Adverse Effects of Strong Incentives >[!question] If paying on the basis out output is so efficient, why is it so uncommon? Issues arise with the [[#Principal-Agent Problem#Taxi Drivers Example|Taxi Drivers Example]], specifically Option 1: - Excess wear and tear - Driver is not incentivized to treat the vehicle properly - They might drive aggressively or risky to accelerate income - No concern about customer satisfaction, safety, etc. - Driver has no incentive to provide good service. They are one of hundreds of drivers among thousands of clients. --- # Factors Affecting Incentive Strength Incentive strength is affected by - Accuracy of the performance evaluation - Uncontrollable vs controllable risks - Uncontrollable risks should not be counted against the employee - Controllable risks **should** be considered - Manipulation - Susceptibility of the metric to manipulation by employees (ex. refusing returns if returns are counted against them) - Distortions and [[#Multitask Incentives]] - Value of employee effort - Importance Sorting #TODO - Subjective evaluation and trust ### Multitask Incentives - A job requires two kinds of effort, $e_1$ and $e_2$ - Employees' disutility of effort $U_d=C(e_1+e_2)$ where $C(x)$ is some function - Employees' contribution $Q=q_1\times e_1+q_2\times e_2$ where $q_{1,2}$ are the outputs of $e_{1,2}$ - Performance measures: $PM_1$, $PM_2$, $PM_3$ - $PM_1=q_1\times e_1+\epsilon_1$ - $PM_2=q_2\times e_2+\epsilon_2$ - $PM_3=\alpha\times PM_1+\beta\times PM_2$ > [!question] How do you balance these incentives? ## Incentive Compensation in Complex Jobs Need to develop better measures or multiple measures of performance: - Combine objective and subjective - Use measures that capture multiple dimensions of performance - Quantity + Quality + Customer Satisfaction Should jobs pay a salary instead of basing compensation on an objective measure? >[!question] How does the firm then motivate performance? >They might use merit pay systems or promotions as their incentives --- # Types of Reward Structures ## Common Types - Bonus w/ floor & cap ## Reward When to use: When you want to incentivize employees to increase output or effort. ### Pros - Directly ties pay to performance - Aligns firm and employee interests - Motivates employees to exert more effort - Helps attract high-productivity workers (sorting effect) ### Cons - Exposes risk-averse employees to income uncertainty - Can encourage metric manipulation - Can lead to neglect of unmeasured tasks ([[#Multitask Incentives]]) ## Punishment When to use: When a minimum performance standard **must** be met, or when cost of underperformance is extremely high (safety-critical roles) ### Pros - Sets clear minimum level for acceptable output - Effective when monitoring is effective ### Cons - Damages morale and trust - Can create culture of fear - Risk-averse workers (even high-output) may avoid the job entirely ## Lump-Sum Bonus, Demotion & Promotion When to use: When performance is evaluated periodically and tied to hitting a defined threshold. ### Pros - Simple - Promotions/demotions are very strong incentives as they are not one-off - Reduces need for continuous monitoring ### Cons - All-or-nothing nature can discourage output once threshold feels out of reach - Demotion is enormous penalty - Can encourage sabatoge ## Bonus with Floor & Cap When to use: When the firm wants to incentivize performance within a target range. Protects against very low output while reducing firm's high-end payout risk ### Pros - Limits firm's compensation costs - Provides safety net that reduced employee income uncertainty - Better for risk-averse employees ### Cons - Minimal incentives above/below the limits - Can create behavior where employees hit limit and stop working - Narrows range of effective incentives ## The Ratchet Effect >[!info] In labor markets, the ratchet effect refers to a situation where workers subject to performance pay choose to restrict their output because they rationally anticipate that firms will respond to higher output levels by raising the output requirements or by cutting pay If your employee earns high pay from an incentive plan, you may be tempted to change the plan to lower pay. Doing so may reduce future incentives - Good performance today --> Lower rewards in the future (because manager reduces benefits from incentives plan) --> "Quota Restriction" #TODO