PowerPoint Slides © Michael R. Ward, UTA 2014

Organizational Size• A Short History

• Middle Ages (500-1700) – sole craftsman had shop downstairs• Early Industrial Revolution (1700-1800) – cottage industry had

handful of workers (Smith’s Pin Factory)• Latter Industrial Revolution (1800-1850) – Rise of the mills with

20-100 workers• Early Industrial Age (1850-1900) – Factory system with 100-1,000

workers per plant• Later Industrial Age (1900-1960s) – Multi-plant firms with up to

100,000+ workers• Information Age (~1960s-) – Smaller firms and smaller worksites

• Parallel History• Large scale agriculture – plantations with up to 1,000 slaves• Military – army with up to 30,000 pseudo-slaves

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Interpretation for Structure• Pre-Industrial Society

• Where there were economies of scale (e.g. plantations and military), a rigid and centralized decision making process was in place

• Otherwise, craftsman was worker/owner

• Industrialization Process• New technologies with economies of scale• Relevant information was increasingly collected by at lower levels• Good decisions often require line workers to exercise discretion• How to align goals of worker with goals of firm so that good

decisions result?

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Auction Service International• 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 • The negotiated “commission” rates were supposed to be

between 10 and 30%, but 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

• What are two possible solutions for this problem?

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Principal-Agent Model• When studying firm-employee relationships we use

principal-agent models• A principal wants an agent to act on her behalf • Agents often have different goals and preferences that

make acting in the principal’s interest costly• The auction house is a principal; the art expert is an agent• “Office Space” scene

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Principal-Agent Model• Agents and Principals have different incentives• The principal must manage the incentive conflict, which

comes down to two problems:• 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”• Moral hazard means that only the agent knows his effort level

• The costs of addressing moral hazard and adverse selection are known as agency costs, because they are often analyzed by principal-agent models

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Reducing Agency Costs• A principal can reduce agency costs if she gathers

information (reduces information asymmetry)• about the agent’s type (adverse selection)• 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

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Incentive Pay• 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)?

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Decision Making Problems• 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: • A performance evaluation system • A reward system

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University Faculty• Ex Faculty are evaluated annually on: 1) research 2)

teaching 3) service• Research – Ranking system of publishing in quality journals,

grants, etc. is rather informative• Teaching – Student evaluations are not very informative• Service – Committee membership activity

• Linkage to pay?• Budget Freeze?• Chair allocates budget increase proportionally?• Outside offer!

• Elaborate evaluation system is useless if not linked to a reward system

• (Also, reward system useless if evaluating wrong metrics)

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Centralize versus Decentralize• How should decision rights be assigned?

• Decentralize decision making: move decision rights down in the hierarchy, closer to those with better information

• Centralize decision making: move decision rights up in the hierarchy, closer to those with better incentives

• Information must flow to decision maker• Information is usually decentralized• If you centralize decision-making, find a way to transfer

information to those making decisions

• Compensate good decisions• Incentive are usually better higher up the hierarchy• If you decentralize decision-making authority, you should also

strengthen incentive-compensation schemes

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Decision Rights Tradeoffs• Is it easier to get the information to flow from its source to

a different decision maker?• Or is it easier to create incentives for the one with the

information to make good decisions?• Or is it easiest to have someone else make the decision?• Depends on specific context• Faculty Example

• Extremely decentralized – e.g., research topic, course content• But weak incentives• Prediction: deadwood

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Performance Evaluation• Informal: using subjective performance evaluation• 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• Ex Bonus, increased probability of promotion, faster promotion ,

first choice in scheduling

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Multiple Objectives• Evaluation of performance on multiple objectives• Ex Convenience store manager gets bonuses tied to 10

meeting formal criteria (e.g., sales targets, promotional product sales, low employee overtime, low employee turnover, low stock-outs, etc.)

• Impossible to meet all but you earn bigger bonus for meeting more objectives

• Do you strive for between 90% and 110% of all objectives or 101% of some and 0% of others?

• Faculty Example – If outside offers based solely on research output, do I care about teaching?

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Sales versus Marketing• Sales and marketing divisions often have incentive conflict

• Sales wants to maximize revenue, i.e., all sales where MR > 0• Marketing wants to maximize profit, i.e., all sales where MR > MC

• In other words, sales prefers a higher level of sales and a lower price than does marketing

• Ex 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)

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Sales versus Marketing• Two solutions to marketing versus sales:

• Centralize sales decisions to marketing; and try to transfer enough information to marketing managers so they know how aggressively to bid (car salesman/manager?)

• Decentralize sales decisions (keep decision rights with the sales people) and change incentives but they have no decision rights over price (shoe salesman)

• Instead of a 10% commission on revenue, give sales people a 20% commission on profit, (revenue neutral if the contribution margin is 50%)• Ex Rockford Files

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Threshold Compensation• How well do threshold compensation schemes work, e.g.,

a bonus if you open hit a target sales number? • How well do high-powered sales commissions work, e.g.,

5% commission for sales of $1M; 10% commission on sales of $2M, work?• Ex Pass Comps with “Incredible Marginality”

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Group Incentives• Group incentives are usually weaker than individual

incentives due to free-riding• Often it is impossible to discern the contributions of each

making any incentive contract a group incentive contract• Ex Incentives for teachers• One incentive scheme was for groups of teachers teaching

the same subject within a grade and school• Linking pay to performance of students across classes has

been shown to improve academic performance (Imberman and Lovenheim, 2012)

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Teacher Group Incentives• Why base incentives on teacher groups and not individual

teachers?• Student performance data available for each teacher• But individual teacher incentives do not seem to work• Possible explanations for better performance with group

incentives:1. Avoids teachers “cherry-picking” students2. Sorts students into different classes – based on student ability

or, say, unruliness3. Captures spillovers within the teacher group4. Demonstrates possibilities to other teacher groups

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Franchising• Incentive conflict exists between franchisors (McDonalds)

and its franchisees (local businessmen)• McDonalds wants big franchise fees and high quality at

franchisees to protect its reputation • Franchisees want smaller fees and lower quality (cheaper)

• Stores are both company-owned and franchisees • In a company-owned store, both adverse selection and moral

hazard are concerns – managers don’t work as hard as owners and salaried manager positions might attract lazy workers

• Franchisees have bigger incentive to work hard (because they are the “residual claimants” of profit) but have to have their quality monitored

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Franchising• Why both company-owned and franchisees?• Where would you expect to see either?• Where is demand greatly affected by manger effort?

• Company run stores tend to be located in tourist areas• Like at freeway off-ramps or inside amusement parks

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Hotel Employees• Ex Confessions of a Hotel Maid

“I cut corners everywhere I could. Instead of vacuuming, I found that just picking up the larger crumbs from the carpet would do. Rather than scrub the tub with hot water, sometimes it was just a spray-and-wipe kind of day… After several weeks on the job, I discovered that the staff leader who inspected the rooms couldn't tell the difference between a clean sink and one that was simply dry, so I would often just run a rag over the wet spots… I apologize to you now if you ever stayed in one of my rooms. You deserved better. But if housekeepers were paid more than minimum wage — and the tips were a bit better — I might have cleaned your toilet rather than just flushed it.”

• How do you motivate this worker?

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Hotel Employees• Motivate maids with informal incentive compensation• It is possible to implement hiring practices characterized

by low initial pay with more bonuses and more merit based pay

• Freedman and Kosová find that, relative to company owned hotels, franchise operations rely more on such hiring practices

• So, to address worker shirking you need to address store manager shirking

• Franchising can help solve this problem

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From the Blog• Chapter 21• High Powered Incentives and Sales Bunching• DC Teacher Incentives• Doing Good• Wall Street reacts to Steve Balmer stepping down

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Main Points• Principals and Agents typically have different goals that

cause an incentive conflict• This kind of incentive conflict is called an “agency

problem” and leads to moral hazard and adverse selection• The costs of the agency problem fall when the principal is

better informed but sometimes the information is too costly• Fixed pay and monitoring• Incentive pay with little monitoring• Hybrid

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Main Points• Decision makers should have necessary information and

appropriate incentives• Decentralizing usually requires stronger incentives at the fringe• Centralizing usually requires enhanced information flow

• Analyze agency problems with three questions:• Who is making the bad decision?• Do they have enough information?• Do they have strong enough incentives?

• Alternative solutions involve:• Changing decision rights?• Transferring information?• Changing incentives?

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