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Incentive Compensation

Incentive Compensation. Incentive compensation learning objectives. Describe the conflict between ownership and risk aversion in designing employment contracts Explain the concept and structure of incentive pay and apply to a specific firm or organization.

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Incentive Compensation

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  1. Incentive Compensation Managerial Economics and Organizational Architecture, Chapter 15

  2. Incentive compensationlearning objectives • Describe the conflict between ownership and risk aversion in designing employment contracts • Explain the concept and structure of incentive pay and apply to a specific firm or organization Managerial Economics and Organizational Architecture, Chapter 15

  3. The incentive problemIan McLeod at AssemCo Ian’s utility function: U=I-e2 Firm’s benefits from Ian’s effort: Firm’s profit from specified level of effort, Maximum profits occur where e=50 • with the help of a bit of calculus • illustrated on the next slide Managerial Economics and Organizational Architecture, Chapter 15

  4. Optimal effort choice at AAC Managerial Economics and Organizational Architecture, Chapter 15

  5. Incentives from ownership • Benefits of ownership • franchising • managerial buyouts • Limiting factors • wealth constraints • risk aversion • team production Managerial Economics and Organizational Architecture, Chapter 15

  6. Optimal risk sharing • Most individuals are risk averse • for given income level, prefer less dispersion in outcomes • Shareholders have diverse portfolios • less concerned about performance of any one company • Employees receive substantial income from single company Managerial Economics and Organizational Architecture, Chapter 15

  7. Effective incentive contracts • Compensation contracts have two functions • motivate employees • share risk more efficiently • Contract must balance these considerations Managerial Economics and Organizational Architecture, Chapter 15

  8. Basic principal-agent modelErica Olsson of DNAcorp Erica’s output: Q=e+, ~(0,2) • output depends on effort and a random element Profit=(e+)-W • profit is output minus Erica’s cost Compensation: W=W0+Q, 0  1 • compensation has a fixed component and an element linked to output Managerial Economics and Organizational Architecture, Chapter 15

  9. The employee’s effort choice Managerial Economics and Organizational Architecture, Chapter 15

  10. Effort choice changes with changes in fixed and incentive compensation Managerial Economics and Organizational Architecture, Chapter 15

  11. Managerial Economics and Organizational Architecture, Chapter 15

  12. Informativeness principle Managerial Economics and Organizational Architecture, Chapter 15

  13. Optimal allocation of effort Managerial Economics and Organizational Architecture, Chapter 15

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