Safelite Auto (B) Incentive Compensation Chapter 15 In-Class Principal-Agent Incentive Model In-Class Student Presentati

1. Safelite Auto (B) Incentive Compensation Chapter 15 In-Class Principal-Agent Incentive Model In-Class Student Presentations

2. Safelite Glass • Did PPP succeed? • What were the problems with PPP? • Should management proceed with the introduction of PPP or even a modified PPP? • What were the consequences of the switch from wage rates to piece rates for: • Turnover • Recruitment • Productivity • Product Quality • Total Labor Costs

3. Safelite Glass • 600 small auto-glass repair centers • 1994 – pay for performance introduced • Hourly wages = f(base salary, glass installed) • Minimum base salary = $11/hr • Must install defectives without pay • Benefits • 36% increase in installed glass/day • Improved productivity per worker • Better workers stay • Decrease in turnover • Costs • Operating: 9% increase in pay/employee • Investment: not high; info system could handle • Net effect • Increase in profits • Source: E. Lazear, “Performance Pay and Productivity,” The American Economic Review, Dec. 2000

4. Basic principal-agent model • Effort not directly observable – use proxy • “post contractual asymmetric information” • Outside risk factor • Could work hard but not all measured => Compensation contract • tie incentive pay to proxy to motivate effort • Include base pay to reduce risk bearing

5. Basic principal-agent model Worker’s output: Q=e+, ~(0,2) • output depends on effort and a random element Profit=(e+)-W • profit is output minus cost of worker Comp. Contract: W=W0+Q, 0  1 • compensation has a fixed component and an element linked to output • Solution • Firm sets Wo and b • Worker maximizes E(U)=E(W-e2) • Worker chooses effort e* = ab/2 • Effort increases with b

6. Basic principal-agent modelRisk If replace some base pay with variable compensation • More variability in pay; increased risk • Must give higher expected compensation (“compensating differential”)

7. Compensating Differential for Bearing Risk: 3 Jobs • $100,000 with 100% certainty • 0 50% of the time $200,000 50% of the time • 50,000 50% of the time $150,000 50% of the time

8. Specific principal-agent model a=$100 u=+$800 with probability 0.50; -$800 with probability 0.50; =0.2 W0=$800 Q=e+ W=W0+Q, 0  1

9. Estimating unknown productivitya • Choosing incentive pay rate requires firm to know productivity (a) • E.g. choose b to elicit effort since e*=ab/2 • Time and motion studies • dysfunctional behavior • Past performance • ratchet effect • Lincoln Electric’s Concern about the ratchet effect

11. Measurement costs • Measurement of evaluation criteria is costly • Accounting system • Data entry time & personnel • Supervisor observation • Record keeping • Accuracy check • Training

12. Opportunism • Gaming • Unethical efforts to alter performance measurements (e.g. Q) • Unintended consequences • I.e. the typist at Lincoln Electric • Evaluation system should be set up to detect &/or reduce the likelihood of opportunism

13. Subjective performance evaluation • Why? Some tasks difficult to measure but should be rewarded • Subjective evaluation methods • Standard rating scales • Goal-based systems • Problems • Supervisor shirking • forced distribution • influence costs • Navy Officer Evaluation System

14. Relative performance evaluation • Measures performance relative to other employees or other firms • E.g. 20% commission on individual sales over average for department • E.g. Bonus earned if market share increases are higher than competitors’ • Benefits • Can lower compensating differential by sifting out outside effects (m) from effort • Alternative: use subjective component to adjust for outside effects • Elicits high competitiveness

15. Relative performance evaluation • Costs • dysfunctional competitiveness • jobs not always identical • data across firms hard to obtain • group has incentive to punish “rate busters” • incentive to hire less competent workers

16. Combining performance measures • Few job performance measures are purely objective or subjective • Both types can be inaccurate • increasing inaccuracy of either places greater weight on other • inaccuracies increase employee risk • Both can induce dysfunctional behaviors

17. Looking Forward • December 6, 7, or 9: Performance Evaluation • Chapters 16 and 17 • Prepare Arthur Anderson Case (ch. 17) • Course Project Due • December 13, 14, or 16: Final Exam • Blackboard: Past Exam Exams • Open book, open notes • Remember to bring a calculator and all course materials