Lecture notes
Incentive alignment
- Module
- Management economics
- Institution
- University Of Exeter (UoEX)
Explores Principle-agent relationships, risk and incentives. Clear definitions and analytic responses
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27.11.19 EconomicsIncentive alignment
Principle-agent relationships
o Used to study firm-employee relationships
o Principle-agent relationship: A principal wants an agent to act on their behalf, but
agents often have different goals and preferences than principals.
- The owner/director of a firm would be the principal, whereas the employee would be
the agent
Incentive conflict
o Due to the agent having different incentives than the principal, the principal must
manage the incentive conflict which comes down to 2 problems:
- Adverse selection: principal has to decide which agent to hire
- Moral hazard: 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’, while moral hazard means that only the agent
knows how much effort he is exerting
o The cost of addressing moral hazard and adverse selection are known as agency costs
when they are analysed in the contest of principle agent models
Agency costs
o A principle can reduce agency costs if she gathers information (reduces information
asymmetry)
- About the agent’s type (adverse selection) or
- About the agent’s actions (moral hazard)
o 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 behaviour while
working
Incentive pay vs. risk
o Incentive pay can help align the incentives of employees (agents) with the goals of the
organisation (principal)
o 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
- Agents must be compensated for taking on this additional risk
o Incentive compensation represents a trade-off
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