Career concerns Simple model Noisy performance Political cycles

Implicit Incentives

Marta Troya Martinez, NES

Lecture 13

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Career concerns Simple model Noisy performance Political cycles Career concerns

Explicit vs implicit incentives

I Explicit incentives:
I they are provided by explicit contractual commitment by
principal
I these have been the focus so far
I Implicit incentives:
I arise when a principal or principals have some ex post
discretion how to respond to agent’s performance
I agent has implicit incentives to change performance to
in‡uence principals’discretionary decisions
I these are necessarily intertemporal incentives

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Career concerns Simple model Noisy performance Political cycles Career concerns

Explicit vs implicit incentives

Contexts in which implicit incentives may be important:

I E¤ort incentives for employees and managers

I Incentives for …rms to provide high-quality products
I Incentives for cost reduction by regulated …rms
I Incentives for appropriate behavior by elected politicians or by
civil servants

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Career concerns Simple model Noisy performance Political cycles Career concerns

Implicit incentives

I Implicit incentives may arise via di¤erent mechanisms:

1. in…nitely-repeated interaction can induce ‘cooperative’
behavior =) self-enforcing (or relational) contracts
2. learning about agent’s intrinsic characteristics (e.g. ability)
2.1 hidden information version: signalling
2.2 hidden action version: signal-jamming
I We’ll study an important example of implicit incentives:
career concerns
I It will be modeled as type 2b)

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Career concerns Simple model Noisy performance Political cycles Career concerns

Overview

I Often agent’s performance is not (fully) contractible

I If we cannot write contracts even on performance, can we still
discipline Agent somehow?
I Yes, if performance signals ability and ability is valuable
I Reference: Holmstrom, 1999, Review of Economic Studies

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Career concerns Simple model Noisy performance Political cycles Simple model

Simple model
I Players: one manager (A) and many identical risk-neutral
…rms
I Two periods: t = 1, 2
I A’s performance is publicly observable in each period
yt = a + et
I et : e¤ort =) privately chosen by A (hidden action) at a cost

c ( et )
=) cost is strictly increasing and convex
I a: A’s ability =) initially unknown to everyone (no hidden

information)
=) prior: a N (a, σ2a )
I Key assumption 1: a is unknown to anyone
I F (a ) –prior distribution of a, common knowledge

I Key assumption 2: yt is observable but not contractible

I Principal can only o¤er …xed wage wt each period =) @

explicit incentives
I Each period wage is determined in a competitive market for A
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Career concerns Simple model Noisy performance Political cycles Simple model

Simple model

I Agent’s preferences:
I Per period utility: wt c (et ) - what’s the agent’s risk
attitude?
I Total expected utility: E [w1 c (e1 ) + δ(w2 c (e2 ))] where
δ < 1 is discount factor
I Firms preferences:
I Competition draws wages to the expected output =) in
equilibrium …rms break-even
I The wage is determined at the beginning of each period
through competition to recruit the worker

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Career concerns Simple model Noisy performance Political cycles Simple model

First best e¤ort

I Suppose that yt is contractible - remember, it was already

observable! What is the e¤ort that maximizes total welfare?
Each period:
max a + et c (et )
et | {z }
w t =y t

I The …rst best e¤ort is:

1 = c 0 (etFB )8t

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Career concerns Simple model Noisy performance Political cycles Simple model

Second best e¤ort

I @ explicit contracts: wt is …xed at the beginning of t =)

does not depend on that period output yt
I w1 = w 1 compatible with break even
I w2 = E [y2 j y1 ]
I The wage in period 2 generates implicit incentives for e¤ort in
period 1!
I What is e2 ? A has no incentive to exert e¤ort in period 2 since
w2 has been already set=) end of the game e¤ect e2 = 0

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Career concerns Simple model Noisy performance Political cycles Simple model

Second best e¤ort

I What is e1 ?
I Firms form a belief e e1 about e1 =) e e1 has to be correct in
the equilibrium: ee1 = e1
I w2 = E [y2 j y1 , e
e 1 ] = E [ a j y1 , e
e 1 ] + e 2 = y1 e e1 =) a is
in fact deterministic, given y1 and e e1
I Agent chooses e1 to maximize

w1 c (e1 ) + δE [a + e1 e
e1 ] = w 1 c ( e1 ) + δ [ a + e1 e
e1 ]

I Equilibrium:
δ = c 0 (e1SB ) and e1SB = e
e1
I First period e¤ort is positive despite the …xed wage!
Intuition: e¤ort increases the market’s belief about agent’s
ability and hence the future wage (career concerns)
I How does it compare to e1FB ? there is underprovision of e¤ort

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Career concerns Simple model Noisy performance Political cycles Noisy performance

New model

I Suppose that A’s performance is noisy: yt = a + et + εt

I εt N 0, σ2ε is noise
I The noise is iid and independent of a
I First-best level of e¤ort is the same:

max Ea,ε [yt ] c (et ) =) c 0 etFB = 18t

et

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Career concerns Simple model Noisy performance Political cycles Noisy performance

Second best e¤ort

I What is e2 ? e2 = 0 for the same reasons
I What is e1 ?
I w = Ea,ε [y j y , e
2 2 2 1 e1 ] = Ea [a j y1 , e
e1 ] + e2 + E ε 2 [ ε 2 ] 6 =
y1 e e1 =) If performance y1 is high, we are unsure whether
it is due to a high ability a or luck (high ε1 )

σ2 σ2
e1 ] = a 2 ε 2 + (y1
w2 = Ea [a j y1 , e e1 ) 2 a 2
e
σa + σ ε σa + σ ε
I Agent chooses e1 to maximize: w 1 c (e1 ) + δEy1 [w2 ]

σ2 σ2
w1 c ( e1 ) + δ a 2 ε 2 + ( a + e1 e1 ) 2 a 2
e
σa + σ ε σa + σ ε
I Equilibrium:

σ2
δ 2 a 2 = c 0 (e1SB ) and e1SB = e
e1
σa + σ ε
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Career concerns Simple model Noisy performance Political cycles Noisy performance

Second best e¤ort

I Career concerns generate a positive, but suboptimal, level of

e¤ort:
σ2
δ 2 a 2 = c 0 (e1SB ) and e1SB = e
e1
σa + σ ε
I When does A work harder?
1. The more informative is the output (lower σ2ε ) about ability
2. The more uncertainty there is about the ability (higher σ2a )
=) In both circumstances, …rms pay more attention to output
when setting the wage so it is more pro…table for A to increase
the output through e¤ort
3. A’s concern with future wages (higher δ)

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Career concerns Simple model Noisy performance Political cycles Noisy performance

Extensions and applications

I We have a unique equilibrium (in pure strategies) because

ability and e¤ort have a simple additive form =) if talent and
e¤ort are complementary:
I E.g., yt = aet + εt =) multiple equilibria are possible, see
Dewatripont, Jewitt and Tirole (1999, Review of Economic
Studies)
I What will happen with the e¤ort in a setting with more
periods? The uncertainty about the ability decreases with
time and, therefore, the e¤ort also declines over time (to zero)
- there is no need to signal-jam the output any more!
I Explicit incentives should be stronger at later stages of the
career, see Gibbons and Murphy (1992, Journal of Political
Economy )
I If ability varies stochastically over time, e¤ort does not
necessarily goes to zero =) E.g., at +1 = at + τ t

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Career concerns Simple model Noisy performance Political cycles Noisy performance

Extensions and applications

Suppose that there are several workers, would …rms bene…t from
using all the worker’s ouputs to infer the ability of a given worker?
This is known as comparative performance evaluation (CPI)
yti = ai + eti + εti
ytj = aj + etj + εtj

I
suppose workers have only correlated shocks ρ = corr (εti , εtj )
=) Firms can use ytj to reduce the variance of "noise" εti
=)then place more weight on yti in estimating ai =)the
worker i makes more e¤ort =) CPI a good idea!
I suppose the workers only have correlated abilities
η = corr (ai , aj ) =) Firms can use ytj to reduce "prior"
variance of ai =)then place less weight on yti in estimating ai
=) the worker i makes less e¤ort =) CPI not a good idea!
=) CPI may be bene…cial but also have unexpected negative
consequences=)Meyer & Vickers (1997, J. of Pol. Economy )
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Career concerns Simple model Noisy performance Political cycles Noisy performance

Rachet e¤ect - implicit "disincentives"

I Employee (A) works for employer (P) for 2 periods, but only
1-period contracts can be written
I A performs the same task in both periods and A’s performance
in period 1 provides information about A’s ability, or about
di¢ culty of task, or about environment, and this information
is useful to P for evaluating A in period 2: Cov (y1 , y2 ) > 0
I P can contract on yt
I At start of period 2, P will want to use this information:
I Good period-1 performance y1 will induce P to judge A’s
period-2 performance y2 against higher standard (“ratcheting
up” of standards)
I Higher y1 implies that for any given y2 , P will attribute less to
A’s e¤ort and more to ability/ease of task/environment, so
that for any given y2 , w2 will be less

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Rachet e¤ect - implicit "disincentives"

I For A, therefore, increased 1st-period performance y1 has 2

e¤ects
I Increased 1st-period reward w1
I Decreased 2nd-period reward w2 - the ratchet e¤ect
I The ratchet e¤ect is an implicit disincentive for period-1
e¤ort: it arises because P designs the period-2 contract in
response to period-1 performance
I Applications:
I workers paid through piece rates
I regulated …rms
I managers in centrally planned economies

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Career concerns Simple model Noisy performance Political cycles Political cycles

Career concerns and politicians

I One of the roles of elections is to select the most competent

politician
I Just before elections, incumbents refrain from rent seeking
because they want to appear talented to imperfectly informed
voters
I This role of election creates electoral cycles: policy choices
made shortly before elections are di¤erent from the ones made
early on in the legislature
I If voters learn politicians’type directly, for instance, through
well-functioning independent media, signal-jamming has no
value to voters and we expect no electoral cycles
I We will look at the theory model of Persson and Tabellini,
2000, ch. 4.5 and the empirical application of Akhmedov and
Zhuravskaya (2004, Quaterly Journal of Economics)

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Career concerns Simple model Noisy performance Political cycles Political cycles

Political cycles
I 2 periods: t = 1, 2
I Voters’preferences:
wt = y (1 τ ) + gt
y –income, τ –tax rate (exogenous), gt –public good provision
I Government budget constraint:
gt = η (τy rt )
I rt –rents extracted by incumbent politician =) rt r < τy
I η –incumbent’ s competence which is unknown to everyone
h i
=) η 1 1
U 1 2σ , 1 + 2σ and E (η ) = 1
I Incumbent’s choice is whether to use the tax revenues to
provide gt
I Voters observe gt but not rt and are obviously better o¤ with
a competent politician
I If a new politician is appointed, η is drawn randomly
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Career concerns Simple model Noisy performance Political cycles Political cycles

Political cycles

I Incumbent’s payo¤ over 2 periods:

v = r1 + pδ(R + r2 )

I R - exogenous rents from relection

I p - probability of reelection =) this is the mechanism that
provides implicit incentives
I What is r2 ? r2 = r =) g2 = η (τy r)

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Career concerns Simple model Noisy performance Political cycles Political cycles

Political cycles

I What is r1 ?
I Voters form a conjecture about the rents in period 1 e
r1
I Then they estimate the talent
g1
e
η=
τy e
r1
I They reappoint incumbent if he/she is more talented than the
expected opposition e
η E (η ) = 1
I Since g1 = η (τy r1 ), e
η 1 is equivalent to
τy e
r1
η τy r1 =)reappointment probability:

τy e
r1 1 τy e
r1
p = prob η = +σ 1
τy r1 2 τy r1

I p decreases in r1 (career concerns e¤ect)

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Career concerns Simple model Noisy performance Political cycles Political cycles

Equilibrium
I Incumbent solves:
max r1 + pδ(R + r )
r1
1 τy e
r1
s.t. p = +σ 1
2 τy r1
I Solution:
τy e
r1
1=σ δ (R + r )
(τy r1 )2
and e
r1 = r1
I Assuming an interior solution:
1
r1 = τy σδ(R + r ) and p =
2
I Equilibrium rents are smaller:
I If the value of winning the elections is large δ(R + r )
I If the uncertainty about the talent is small (σ large)
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Career concerns Simple model Noisy performance Political cycles Political cycles

Testable implications

I How can we use the above framework to generate electoral

cycles?
I Increases in (certain) government expenditures, decreases in
taxes, changes in unemployment, in‡ation,... before elections
(and reversion after elections)
I Modi…cations:
I Competence is not …xed but evolves stochastically
I On-election periods, incumbent’s problem will be essentially
the same as in the previous model =) incentive to decrease
rents

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Career concerns Simple model Noisy performance Political cycles Political cycles

Political cycles in Russia

I Look at the results of Akhmedov and Zhuravskaya, (2004,
Quaterly Journal of Economics)
I While theories predict political cycles, evidence on developed
countries has been weak =)If voters learn politicians’type
directly, for instance, through well-functioning independent
media, signal-jamming has no value to voters
I Perhaps we should look at immature democracies, where
voters are unexperienced and information about politicians
and their policies is not precise
I Literature on young/imperfect democracies obtains stronger
results although, many studies su¤er from low frequency of
data and too high aggregation of …scal spending
I Akhmedov and Zhuravskaya look at monthly data and
disaggregated spendings
I Sample: 194 governor elections in period 1995-2003
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Career concerns Simple model Noisy performance Political cycles Political cycles

Hypotheses

I Political cycles exist in Russia =) which kind exactly? Look

at various public expenditures, composition of budget, growth,
in‡ation
I Voters’awareness (measured by education and urbanization)
and transparency (indices of government transparency and
media freedom) reduce cycle magnitude =) If voters are
better informed about the ability or actions of the ruler, the
incentive for electoral cycle is lower
I Cycles become smaller with time =) learning by voters +
improvement in transparency as civil society develops
I Note: not so easy to test in this sample, as change from
Yeltsin to Putin occurred in the middle

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Career concerns Simple model Noisy performance Political cycles Political cycles

Data

I Russian regional governor elections 1995-2003 (194 events)

I Monthly series on …scal instruments and outcomes from
Goskomstat and Ministry of Finance
I wages, incomes, prices, industrial output, regional budgets
execution
I Urbanization and education –from Goskomstat
I Media freedom –from Institute of Free Media
I Transparency of regional governments –from "Media-Soyuz"
(independent professional association of Russian journalists)
I Democracy scores from Carnegie Moscow center

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Empirical results: cycles

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Empirical results: determinants of cycles

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Do cycles help winning?

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Career concerns Simple model Noisy performance Political cycles Political cycles

Conclusions

I Sizable opportunistic cycles in …scal policies

I Most vivid increases in budget spending occurs 1-2 months
before elections. Reversion is very quick (1-2 months)
I Magnitude of cycle decreases with democracy, government
transparency, media freedom, voter awareness, and over time
I Preelectoral manipulations help to get reelected

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