This document is a summary/recap of Incentives and Control PLUS the audio explanations given by the professor. The summaries that exist about this field do not give additional information given by the professor (e.g., importances, more explanations, etc.). This one does and is cheaper :)
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Summary of course objectives:
- Develop understanding of incentives & control;
- Develop understanding of research on incentives & control; and
- To be able to apply incentives & control perspectives to real-life settings
1.2. Incentives & Control Systems (Week1 slide9_37).mp4
Introduction into Economic Models
Assume you are a sales representative with a choice of two alternative compensation contracts.
Which contract do you prefer?
- First option: Fixed compensation of €200.000;
- Second option: Fixed compensation of €100.000 and possible bonus of €200.000.
- Have considerable influence on meeting the sales target, but external factors also affect
whether you are going to make the target (estimate: 50% likelihood).
Most people prefer the first option over the second option. This is referred to as risk-
aversion.
- Two basic assumptions of economic models:
o Greed (prefer more over less);
▪ Utility increases with each additional
unit of income.
o Risk-aversion.
▪ Utility increases at decreasing rate
with each additional unit of income.
This is illustrated through concavity of utility function →
People like more over less, but to a degree to which you enjoy
more starts to decrease at higher amounts of income. The
more you earn the more your happiness starts to decrease.
- Another assumption refers to information asymmetry (private information)
Information asymmetry: other people have more information compared to other people (not
having the same information).
Three types of Asymmetric Information Models:
- Moral Hazard (!!): Hidden actions/effort + uninformed party moves first;
- Screening/Adverse selection: Hidden characteristics + uninformed party moves first;
- Signaling: Hidden characteristics + informed party moves first.
About what do we have information? → Hidden actions/efforts (what I do), or hidden
characteristics (things that I know, that other people do not know).
Uninformed party doesn’t have private information and the informed party does have
private information.
,Moral Hazard:
- Agent (subordinate) has private information about effort choices;
- Misalignment of interests between principal and agent;
o Agent may prefer leisure activities over productive (and costly) effort.
- Principal (superior) elicits high effort and desired action choices by offering contracts
contingent on performance measures rewarding agents for productive effort.
- Example:
o Incentive compensation contracts.
Screening/Adverse selection:
- Agent has private information about characteristics;
- Principal induces agents to truthfully reveal their private information about its type by
offering contracts beneficial for high type, but not for low type. (health insurances, different
types of packages depending on how often you have problems / sicknesses)
- Examples:
o Health insurers providing plans with higher premiums and coverage s.t. only certain
people self-select into those plans; and
o Firms provides strong incentive pay s.t. only certain people self-select into those
firms.
Signaling:
- Agents communicate their type to principal by taking actions less costly to the high type
(relative to low type);
- Requirement for credible communication about its type (‘separating equilibrium’ (less costly
for you than for someone else) instead of ‘pooling equilibrium’ (copy and paste the same
strategy)).
- Examples:
o Education as signaling device (abstract from increase in marginal productivity); and
o Higher education is more costly for low type, so for high type credible way of
communication about ability.
What is the scope of “Incentives & Control”?
- Many organizations are characterized by:
o Asymmetric information (some members have informational advantage); and
o Some people have personal objectives that are not perfectly aligned with corporate
objectives.
- Focus of the course is on contribution of various methods and techniques to the challenge of
aligning interests of employees with the overall organizational objectives in settings
characterized by asymmetric information.
Why do incentives & control problems emerge?
What do we need to make good business decisions? -> Knowledge and authority to make decisions.
- Knowledge is valuable in decision making;
o Co-locate decision rights with knowledge important for making those decisions.
- Knowledge is often dispersed throughout the organization;
- Two alternatives:
o Moving knowledge to those with decision rights (KTC); and
o Moving decision rights to those with knowledge (CC);
Knowledge transfer cost (KTC) depends on nature of
knowledge, organizational volatility, technology.
, - We distinguish between:
o Specific knowledge → Costly to transfer; and (riding a bike, easy to do here, but you
cannot explain it how to do it)
o General knowledge → Inexpensive to transmit.
- Specific knowledge necessitates decentralization of decision rights.
o This creates two problems:
▪ Rights assignment problem; and
▪ Control / agency problem.
- What can we learn from outside markets?
o Markets have a system of private, alienable rights (license);
▪ Alienability is right to sell/transfer rights and right to pocket the proceeds.
o Rights are now acquired by those who value the rights the most;
o Market prices reflect present value of future cash flows from current utilization and
thus provide rewards and punishment as a result of their decisions;
o Not applicable for firms as e.g., employees do not receive rights to alienate decision
rights under their control. (a commercial pilot can fly the plane but not sell it)
▪ Question becomes to what extent firms should decentralize decision rights?
Costs due to poor information → Centralized → HQ, make all decisions, all knowledge cannot be
transmitted to HQ → High costs to poor information.
Costs due to inconsistent objectives → Decentralized → No all product managers make decisions
that are right for the firm → High costs of inconsistent objectives.
- Optimal level of delegation:
o Trade-off between cost of poor information vs. cost of inconsistent objectives;
o Typically employees are not assigned total decision rights to make any major
decision; and
▪ Breakdown of decision rights in e.g., initiation, ratification, implementation,
and monitoring rights.
o Subsequently, provide rewards and punishments tied to performance measure
outcomes.
, - Bottom-line:
o Partition decision-making rights throughout organization create incentive system
that:
▪ Provides measure of performance; and
▪ Specifies relationships between rewards and punishments and performance
measure outcomes.
Framework of Merchant & Van Der Stede
- More comprehensive system composed of:
o Result controls;
▪ Define performance measures and reward good results (and punish bad
results).
o Action controls; and
▪ Focus on employee behavior to ensure that employees perform (do not
perform) actions beneficial (harmful) to the organization.
o Personnel and cultural controls;
▪ Based on self-control and social control.
- Two design choices in this framework.
o Which combination should be used, and how tight should each of the controls be?
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