Managerial Economics and Organizational Architectu re, Chapter 15 Incentive Compensation
Dec 31, 2015
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
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
Effort choice changes with changes in fixed and incentive compensation