Contracting - Structuring Employment Agreements
Our second problem when dealing with inputs: Getting the Most Out of Human Inputs!
What is the best compensation structure for labor?
Standard production theory assumes that all employees work efficiently, all the time. Of course this is not true. Workers in factories “shirk”, which means:
The basic problem is: Managers often care about things other than the value of the firm.
Sports players attempt to do something other than “win” for example
Align the Interest of Employee with the Interest of Owners: Of course, no human factor is efficient all of the time. However, one can improve the motivation of employees by constructing contracts that align the interests of employees and management. Importantly, this task is not easy.
Example: How do you structure the contract of a basketball player? Flat salary, points scored? Assists? Winning?
In general there are a number of dangers to attend to .
a) Stock price. Useful for a CEO, of limited use when employees cannot themselves affect materially the profitability of the firm.
b) Flat salary: Does not motivate a lot of effort, but can provide needed security.
c) Time clocks and monitoring: Generally, people do not respond well to “sticks:” Time clocks can be important when an entire group must be present to initiate a task. If monitoring is to be done, it must be random
d) Piece rate compensation: A good scheme when quality is not an issue. (great for catching chickens. Terrible for paintings or poems)
e) Sales commissions. Great unless costs are a problem. Also sales workers may undermine each others’ efforts.
Conclusion: Motivating employees is a difficult task. But notice also, that most people really want to do a good job. Be careful to not undermine good intentions.
So let's get to the bottom line: Our goal is to make arrangements or contracts which increase the output of the worker net of costs.
A manager should look for two things:
1. devices which enable him to better manage those workers under his supervision because this will increase his productivity as a manager;
2. devices or mechanisms which he can propose to his supervisor to increase his own productivity because this will increase his value as a worker and therefore his wage.
Theory of Agency
Again, workers will pursue their own goals instead of that of the firm. Workers can do this because information is not perfect. If a manger notices a drop in sales from a salesperson -- is that due to shirking or something else?
Therefore there are agency costs:
Agent:
Principal:
The problem:
Classic example with a corporation (separation of ownership from control):
There are many different kinds of shirking -
- not doing the work
- acceptance of bribes from vendors by purchasing agents -- will choose goods and services for the firm that benefits him instead of the firm
- influence activities - as in having a party for the new Dean of SOBA
- etc.
Employers will try to decrease shirking but usually not to zero (that is not "optimal") - why?
How? The structure of the contract is important.
- make goals of the workers as close as possible to that of the firm.
1. Extreme method to decrease shirking: simply use the labor market to perform each task.
But: transaction costs?
2. Next -- pay strictly on a productivity basis
But: how to measure?
A major determinant of the form of the contract will be the relative ease of monitoring the inputs.
Why not pay entirely on productivity?
After all, any payment scheme which weakens the link between productivity and pay creates agency and shirking costs. So there are benefits associated with these kinds of contracts. Benefits include: risk aversion - putting all of the productivity responsibility on the worker increases his or her risk (may not make money or not and the firm isn't bearing the risk). Most workers will ask for a risk premium -- will have to pay them more.
This doesn't mean that contracts imposing risk on workers could never be used. It may be that for some jobs, the costs of shirking more than outweigh the risk premium - so what would the manager do in this case?
When would you see these contracts -- when shirking is expensive and hard to monitor.
Many outside sales people are paid entirely on commission for this reason.
Maybe have a payment system that has some fixed amount of pay and some pay based on productivity.
Monitoring to Avoid Shirking
A basic function of a manger is to monitor -- but the problem is: who will monitor the monitor?
Ways of dealing with this?
1. Make the monitor owner.
How: franchise, stock options.
2. Tie the reward to productivity.
How: pay based on productivity, commissions, bonuses, performance quotas, etc.
GRAPH (MB and MC to the worker - commissions):
What about Performance Quotas?
Minimum standard of performance: below which penalties apply:
-deferral of promotion
-decrease pay
-dismissal
GRAPH (MB and MC to the worker - performance quota):
Cost effective: worker chooses quota level.
When would this not work?
3. The market for managers will monitor -
4. The market for corporate control will monitor -
What About Team Production?
Another reason not to use the market -- team production is more efficient.
But - shirking is high due to:
So need a monitor --
But who will monitor the monitor?
Answers above -- but best may be that the monitor should be the owner.
Is this a reason for franchising perhaps? Explain.
Contests
A contest may serve as the best method of rewarding workers. This is especially true if output depends not only on the team effort - but on individual effort that can be determined - plus there are outside factors that change productivity.
The focus is on the worker's relative -- not absolute -- productivity.
Therefore -- it is competition among workers.
Common with salesmen - bonus or free vacation.
Question: Why would it ever be worthwhile to pay a higher salary to the winner of the contest than the job itself would demand?
Downsides:
1. what about absolute performance?
2. contests create incentives for managers to attempt to harm others so as to come out ahead themselves.