Managerial Economics and Organizational Architecture, Chapter 15

Incentive Compensation

Managerial Economics and Organizational Architecture, Chapter 15

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

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

e)e(1000-e100P 2

Managerial Economics and Organizational Architecture, Chapter 15

Optimal effort choice at AAC

Managerial Economics and Organizational Architecture, Chapter 15

Incentives from ownership

• Benefits of ownership– franchising– managerial buyouts

• Limiting factors– wealth constraints– risk aversion– team production

Managerial Economics and Organizational Architecture, Chapter 15

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

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

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

The employee’s effort choice

Managerial Economics and Organizational Architecture, Chapter 15

Effort choice changes with changes in fixed and incentive compensation

Managerial Economics and Organizational Architecture, Chapter 15

Managerial Economics and Organizational Architecture, Chapter 15

Informativeness principle

Managerial Economics and Organizational Architecture, Chapter 15

Optimal allocation of effort