LECTURE 6 / C3: MONITORING

Essential reading
H & B: 410 – 17, 427 – 43, Chapter 3.

Aim of the chapter

To provide an understanding of how an organisation can be conceived as a
monitoring mechanism.

3.1 INTRO: ORGANISATION AS A MONITORING MECHANISM

One way of analysing an organisation is as a monitoring mechanism. The

hierarchical division of labour is then viewed as a complex monitoring
structure. In practice, of course, monitoring is mingled with the other
mechanisms we have identified, particularly incentive mechanisms, but it is
analytically insightful to separately consider hierarchies as monitoring
mechanisms.

By and large, it is sociologists and to a lesser extent psychologists who have

studied the variety in these mechanisms. Economists have usually linked
monitoring with incentives in PA theory, by asking questions about optimal
incentives → Chap 4.

Monitoring and incentives are inextricably linked: the more effective the latter,
the less of the former one needs. As we noted in Chapter 2, there are two
fundamentally different ways P can monitor A. For example, a first line
manager or supervisor (P) can monitor a worker (A) by observing his input
(effort) and output (product). P is A’s hierarchical ‘superior’ so he is monitoring
A who is in his span of control. (P has a span of one.) All this might sound
obvious but when we come to study power mechanisms, the hierarchical
division of labour becomes a process of mutual monitoring up and down a
hierarchy. Let us put this idea to one side for the moment and take what we

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might quite naturally term a ‘top-down’ viewpoint. P would, in a conventional
sense, be called A’s manager.

3.1.1 Monitoring & Observation Cost

Some important terminological issues, nevertheless, arise in making
economists’ and sociologists’ perspectives on monitoring consistent with
each other. When referring to monitoring, economists usually mean ‘costs
of observing’ or perhaps even ‘costs of observing and drawing useful
conclusions’. So, if P can ‘costlessly’ observe A’s output or input or infer the
latter from the former, there is literally no need for monitoring. Perfectly
competitive markets at equilibrium prices have this characteristic. Some
sociologists, though, assume that there is no such thing as costless
observation so they find that monitoring is universal. But as long as
we are aware of this and interpret ‘monitoring mechanisms’ as costly, then
no difficulties should arise. Of course, economists have standard ways of
talking about the efficiency of monitoring mechanisms which equate
benefits and costs at the margin (→ Chapter 4).

Two further points. First, you will find economists also using the term
‘signalling’, whereby the motive to reveal information for monitoring
purposes can be examined. Second, economists sometimes distinguish
between verifiable observations/signals which can be described ex ante (as a
result of something done before) and verified ex post (after the fact) to a third
party such as a court of law and can be used to specify a formal contract,
from observations which fail this test. Observations are more likely to be
associated with what sociologists call informal monitoring. In sum, it is
probably useful to distinguish between the following:

• ‘Costless’ observation of inputs/outputs (usually some sort of

ideal type).

• Monitoring costs: the cost of the time and effort devoted to

observing inputs/outputs. The costs of the administration component

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 (→ Chapter 10) may be partially attributable to monitoring costs,
though the administrative hierarchy has many other costly functions.

• Monitoring intensity: the time devoted to monitoring which

implies monitoring costs.

3.1.2 Monitoring & Incentives

We may formulate the monitoring and incentive problem as follows:

a. Assume the output of A is dependent solely upon A’s ‘effort’.

• P knows this to be the case.
• P can observe/monitor A’s output and infer the ‘effort’.
• If A’s output is straightforward, P will have to devote few
resources to monitoring A. P’s span of control (supervision of
many As) can go up. P has no need to monitor A’s input, which
would be costly (i.e. constantly watching A).

b. or Assume either P does not know the relationship between A’s

effort and output; P cannot ‘easily’ observe A’s individual output (e.g.
A is a member of a group / team which produces a ‘collective output’ or
A’s output is dependent upon his effort and other factors which are
costly to observe by P
• P will face a more difficult monitoring problem. P will have to
devote time and effort in attempting to overcome the monitoring
problems (monitoring costs and intensity).
• This will negatively impact the span of control of P.
• If the performance of various agents in a span of control are
interdependent, then it will be the span of co-ordination which is
affected.

In practice, organisational monitoring combines a mixture of observing

inputs and outputs.

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3.1.3 Monitoring & Hierarchy (Span of Control)
Sociologists, following Weber, picture a bureaucratic organisation as utilising
procedures whereby P both sets the rules for A (implicitly signs the contract
with A) and monitors A’s performance.

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A span of control (remember that a hierarchy is built of spans of control) is
thus a mechanism for both directing and monitoring. The more time/effort P
has to put into these activities, the lower his span of control will be (i.e.
number of subordinates).

If we extend the picture to situations which, because of uncertainty, cannot

be entirely covered by rules / contracts (i.e. incomplete contracts) then
discretion will arise. This complicates monitoring. The discretion can be
either decentralised to A or centralised with P. If it is decentralised then P
will monitor, ex post, A’s decisions in handling the discretion. If it is
centralised, P will handle the discretion himself and issue appropriate
directives. (→ Chap 12). They will have an impact upon the span of control
and thus the hierarchical division of labour.

An organisational hierarchy can be viewed as a complex structure designed to

co-ordinate and control human activities through direction and monitoring.
Figure 3.1 depicts a simple hierarchy with various spans of control and a
depth of four.

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It is natural to think of the bottom of the hierarchy as the ‘production line’
– though this might be a rather awkward term if we are talking about, say,
a church. As we move up the levels we encounter first line supervisors
(with spans of two and three) and then second line supervisors with spans of
two; and so on. Viewed this way, the hierarchy is a structure of cascading P–
A relationships devoted to directing and monitoring.

This enables us to introduce an important concept – control loss.

(Neither textbook introduces the concept.)

DEFINITION: Control loss across two hierarchical levels (i.e. superior-

subordinate) is defined as the extent to which the subordinate (agent) fails to
carry out the intention of the superior (principal). Thus, aggregated across all
hierarchical levels, control loss represents a measure of the managerial
inefficiency of the firm. Williamson ( 1970) holds that control loss leads to self-
aggrandizement by managers through empire building and the like – known
as residual loss in PA theory terms.

If we take a top-down standpoint on the objectives of the organisation then

we can envisage it as lines of control running downwards from the peak co-
ordinator. There are as many links in a line as the depth of the hierarchy. The
hierarchy depicted in Figure 3.1 has 10 such lines. For a hierarchy to
effectively control and co-ordinate the activities of its constituent members,
the activities of ‘production line’ members must contribute to the objectives of
the first line supervisor which, in turn, must contribute to the objectives of the
second line supervisor, and so on up to the peak co-ordinator. To the degree
that this is not the case then there will be control loss. Since we have
incorporated the idea of co-ordination into our definition of organisation, we
might also refer to co-ordination loss (→ Chap 12).

To get an impression of the nature of these important concepts, you might

think in the following terms: attach an (independent) probability number
to each link in a hierarchical line of control measuring the extent to which
the activities of the subordinate member contribute to the objectives of the

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immediate superior. Then the control loss down the line is computed by
multiplying these numbers together and subtracting from 1. If they are all
100 per cent, then there is perfect control or no control loss. If, however,
any depart from 100 per cent, then we find control loss. Notice that the
longer the line (the depth of the organisation), the more likely it is that we
shall find control loss and even small departures from 100 per cent will
have a dramatic effect (for example, multiply 0.99 together four times).

3.2 TAYLORISM AND FORDISM

The balance of scholarly activity has centred upon the direction and
monitoring of the ‘workforce’ or bottom layer in organisations. Taylorism (or
scientific management) and its development as Fordism have had a profound
impact upon the study of direction and monitoring.

3.2.1 Taylorism

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Taylorism (with its alternative name scientific management) is a process
whereby activities are decomposed / fragmented
into simpler components. Taylorism can facilitate
the production line, which with the addition of
mass consumption is usually referred to as
Fordism. The term ‘Fordism’ is thus used to
describe a wider socio-economic phenomenon
which became pre-eminent in industrialised
economies until the 1970s. Taylorism / Fordism
spread from the US to other advanced
economies from the decade following the First
World War, and though its credentials were called into question in the latter
half of the 20th century, it continues to have a hold on the organisation of
work and design of organisations.

Once again, using a di-graph depiction is helpful. Figure 3.2 illustrates

some decompositions.

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In Figure 3.2 (a), the complex task is decomposed into four simpler tasks
which are sequentially organised. The operational procedures for each task
are then formulated as relatively simple rules and targets (routinisation). In
general the work flow can be depicted as a di-graph, and the other digraphs in
Figure 3.2 are possible examples.

Taylorism focused upon the lowest level in the hierarchical division of labour
although the ideas also had some impact upon the decomposition of
managerial tasks.

The advantages of decomposing complex tasks into simpler ones are:

a. It reduces the difficulty (costs) of monitoring by increasing the

transparency between inputs and outputs.

b. It increases the spans of control of first line supervisors and

accordingly decreases the administrative costs (overheads). It
increased the speed of production.

c. It increases the capacity of management to control and co-

ordinate labour by making performance more transparent and

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 simplifying the incentive system. There are clear job expectations
and financial rewards.

d. It enables managers to reap the benefits of mass production,

economies of scale and increasing plant utilisation rates.

Although Taylorism and Fordism were initially applied to manufacturing

(particularly cars), the ideas can be applied to the provision of services and to
people servicing and handling organisations. It is generally held that, although
Taylorism was devised and proposed as a ‘scientific’ method of organising
(controlling and co-ordinating) human activities, it had wider implications:

a. It de-skilled some categories of labour (although the link

between de-skilling and re-skilling is a complicated one). It reduced
the need for training.

b. It reduced the bargaining power of labour. By simplifying tasks,

Taylorism decreased the information asymmetry about the nature of
work which traditionally benefited skilled labour. There is less reliance
on scarce skills. It reduced the degree to which the production
process could be slowed down up by units of labour – they became
more easily replaceable. (However, as the system evolved, labour also
was increasingly demotivated to use any residual ‘tacit information’ to
improve production.)

c. It increased the bargaining power of management and ultimately

the owners of organisations; management’s adverse selection and
moral hazard problems in monitoring labour were reduced.

d. It created a role for two new categories of labour namely,

maintenance and quality control workers (inspectors). Both are
removed from direct involvement in production but with significant
bargaining power. They became essential to the smooth running of
particularly the production line (→ Fordism). A new form of information

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 asymmetry evolved, conferring power to management. These workers,
being in relatively small numbers, were able to use their bargaining
power to elevate their relative wages.

e. It facilitated the transition from skills-based to mass trade unions.

Taylorism was an American invention and it is argued that the particular

circumstances of North American society were conducive to its genesis and
growth. In this respect the potential of home mass markets and the relative
disorganisation of skilled labour and lack of trade unions are often cited.

Accordingly to other societies (e.g. Germany) where neither of these

conditions was present, Taylorism was less successful. It is important to
understand what Taylor and those who advocated his ideas had in mind when
describing their prescriptions as scientific.

Firstly, the label ‘scientific management’ clearly gave a legitimacy to the

prescriptions; to describe something as scientific is to imply that it is in some
sense correct. But, more importantly, Taylor believed that the precepts of
scientific management would, if systematically applied, guarantee improved
efficiency and thus both management/owners and labour could share in the
fruits of this improvement. The fragmentation of labour and appropriate
incentives would, indeed, lead to a Pareto improvement (i.e. all could be
better off). When Taylor was promoting his ideas, the US was very much
moving in tandem with the ‘progressive movement’, which embraced science
and technology as the forerunner of the good society.

Second, Taylor tended to see people as most economists do: workers are
motivated solely by financial incentives and as effort – shy (lazy).. He also
believed that quality would be improved and monitoring costs reduced with
the routinisation of production tasks. The design of the fragmented labour
process was clearly, in Taylor’s mind, also the prerogative of management.
Though these may have been reasonable assumptions, particularly in North
America, they became progressively less convincing as the decades passed.

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Furthermore, in societies with deeply embedded cultural traditions which
commit people to the intrinsic value of skilled work, diffusion was difficult.

3.2.2 Fordism
Fordism may be defined as Taylorism, developed as the production line,
along with a strong emphasis on economies of scale (minimising unit costs)
and mass consumption. It is thus usually used to describe the period in
advanced industrial societies from the development, by Henry Ford, of the
production line (1914) up to the 1970s.

Since then, the virtues of the production line have increasingly been called
into question, but not entirely so, and the phrase ‘post-Fordism’ is sometimes
used to characterise this subsequent period.
The production line
evolved, courtesy of
Taylorism, from craft-
based production. In
craft production, the
product (e.g. an early
automobile) occupied
a fixed position on the
factory floor and components were conveyed from stock (inventory) and
assembled at this point. The stock might have been produced in-house or
bought in ( ‘make or buy’ → Chap 10). The information required to effect co-
ordination and control was significantly in the hands of the skilled workforce.
Contracts (rules) were not formalised and highly incomplete. Management
was dependent upon the goodwill of the workforce and inevitably
decentralised much discretion to the shop floor. The effort level exerted by
individual workers was by no means transparent to management though the
group output was. Organisations were relatively small by later 20th-century
standards and had wide spans and few levels. The system was probably
reasonably stable as long as the potential power (→ Chap 6) of skilled
workers was used for the benefit of the organisation / management. This
control loss becomes a serious problem.

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The production line, in contrast, conveyed the product to a sequence of fixed
production positions (micro-vertical integration). Skilled labour gave way to
semi-skilled labour and the amount of buying-in declined.

Individual effort levels became more transparent to management and

determined by the speed of the production line. Contracts (rules) became
formalised and more complete. Discretion was almost eliminated. First line
spans of control remained high, reflecting the ease of monitoring. Spans were
also high under skilled labour assembly. This brings out the point that identical
spans can originate for quite different reasons. In the case of skilled assembly,
decentralised discretion and co-operative labour relations permitted high
spans. The (less skilled) assembly line, on the other hand, achieved the same
objective by reducing discretion and simplifying the monitoring.

Payment systems (→ Chap 4) were rather variable, probably reflecting the

increasingly contested nature of the speed of the assembly line. Time pay
(wage rates) led to annual disputes about rates whereas payment by results
led to continual, often costly, negotiation between management and labour (→
Chap 5).

The success of the production line and mass production depended upon
mass consumption. Ford facilitated this by boosting the wages of his workers
and introducing credit, enabling them to purchase the cars they had produced.
As the emphasis upon consumption spread throughout the industrial
economies, it is sometimes claimed that this encouraged the state to engage
in demand management and paved the way for Keynesian economics. By the
1960s auto workers were among the highest paid in industrial societies and
this fuelled a debate about the role of the ‘affluent worker’.

Production line technology proved less attractive in those countries (e.g.

Germany) where skilled labour persisted, as small companies continued
to play a strong role in the economy and as national mass markets became
more difficult to establish. As the 20th century wore on, Fordism became

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increasingly vulnerable to a number of socio-economic developments both in
the advanced and in the industrialising economies:

a. Low-wage industrialising countries could adopt the assembly

line, etc., and undercut the high-wage economies (eg Japan, Korea,
Malaysia).

b. Mass consumer markets began to move into more specialised

markets, which also increasingly placed emphasis upon product
quality (sometimes called the ‘BMW effect’). This often required
cooperation of labour and increased discretion over quality.

c. Flexible technologies were developed.

a. Resistance to de-skilling in the assembly line (see next section).

To Be Continued

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 LECTURE 7: C3 MONITORING (Con’d)

3.3 THE DE-SKILLING DEBATE

Work on the assembly (production) line is tedious for workers for these
reasons:
a. simple repetitive tasks
b. work rate controlled by the speed of the line
c. little pride in production or product
d. no involvement in the design of work
e. boredom
f. minimal discretion and power.

Although the division of labour in the assembly line did increase productivity, it
was explicitly designed to reduce worker skills. The reaction of workers to
these conditions was complicated, varying with individual characteristics over
time and with cultural context. On the one hand, increased affluence enabled
some to take an entirely instrumental (pragmatic) attitude to their work,
accepting relative affluence as a suitable reward for the unpleasant nature of
their work experience. On the other hand, others increasingly showed
resistance which produced a serious monitoring problem.

De-skilling was interpreted particularly by sociologists as leading to both

objective (via technology) and subjective feelings
of alienation from work and to proletarianisation (a
homogeneous unskilled labour force versus the
few elite rich employers in one’s firm). This line of
analysis was particularly noted by Marxists (→
Chap 5). Harry Braverman’s Labor and Monopoly
Capital (1974) is the most influential book to argue
that de-skilling was, at that time, a near universal
trend in capitalist societies. It is now almost
universally held that Braverman’s thesis was over-

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simple – varying trends in what is often termed by sociologists ‘the labour
process’ are now acknowledged. H & B give a well-balanced overview of this
debate – the story is one of both up- and down-skilling.

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The important lessons we can learn for organisation theory from this
emotional and politicised debate are as follows:

a. Developments in technology can have a strong influence upon

patterns of monitoring (and incentive) systems and thus on
organisational control and co-ordination and, ultimately, design.

b. Sometimes, equally effective alternative technologies are

available, each respectively allowing some discretion to hierarchical
subordinates. This then creates a choice of technologies.

How this choice is resolved may depend on the relative power of managers /
owners and subordinates within firms and in wider society (→ Chap 6). It may
also depend on prevalent cultural values and trust between management and
subordinates (→ Chap 7).

3.4 TECHNOLOGY → NATURE OF MONITORING

Taylorism/Fordism → Control / co-ordination mechanisms → Design of Orgns

(Production (Monitoring, (Vertical,

technology and incentives, horizontal
other determinants power authority etc) hierarchical)

The above causal relationship shows that production technology in Taylorism

and Fordism has an impact on co-ordination and control mechanisms. This is
known as ‘technological determinism’, which is contrasted with the idea of
choice. Perhaps technology is just one determinant among possible others in
shaping the control and co-ordination mechanisms. Unfortunately the
literature is not always analytically precise, eg. H & B’s concept of social
technology.

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Although these concepts are all ultimately interrelated, it is important initially
to keep them analytically separate. For the moment, we are interested in the
degree to which technology may determine the nature of monitoring.

3.4.1 Choice of technology + Choice of monitoring

First however we need to be clear about the converse term ‘choice’. It is
important to distinguish between the choice of (production) technology and
the choice of control and coordination mechanisms (including monitoring)
given a particular technology.

H & B’s chapter is written from a sociological perspective. It might be

useful to consider how economists would address the issues raised.
Unfortunately, D and S don’t really discuss these issues.

Economists always start from the idea of choice. So firms (i.e. their
Principals) will choose both a technology and control and co-ordination
mechanisms, but competitive forces will constrain them, eventually to adopt
the most efficient procedures. So it is in this sense that they are determined. It
is implicit in the adoption of a number of the work design systems from
sociologists and psychologists that they often fail to set their ideas within the
framework of efficient control and co-ordination.

The economists’ reasoning can break down under either of two circumstances:
a. if competitive conditions do not hold
b. if there is ‘more than one best way’ of achieving efficient outcomes.
This latter possibility is called ‘equifinality’.

If there is choice in either of the above respects, then other factors will shape
the technology chosen, the job design and the control and coordination
mechanisms (including monitoring) adopted. It has been suggested that
Principals and their managerial agents may continue to choose technologies
and job designs that minimise the skill and discretion (and thus the bargaining
power) of workers. There is, however, no systematic evidence of this.

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H & B introduce a number of attempts to alter the production line. They
include:
a. job enlargement (reducing fragmentation in the division of labour)
b. job enrichment (increasing discretion / autonomy)
c. job rotation (multiple jobs)
d. autonomous work groups (increasing the discretion/autonomy
given to work teams which self-manage their division of activities)
e. flexible specialisation
f. self-management
g. empowerment
h. lean production.

All post-Fordist attempts to redesign the organisation of work now

acknowledge
the importance
of conceiving of
a social-
technical
system.
This merely
means that
when adopting
a technology
and designing
jobs, it
is imperative to
take into
account not
only the
anticipated
efficiency of the
monitoring mechanism but also people’s reactions to the job design (eg level
of motivation and willingness to innovate). These issues are, however, best
considered under the heading of incentives.

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3.4.2 Uncertainties
As we noted at the start of this chapter, from an economist’s perspective,
the need to monitor activities within an organisation in theory only arises if
the incentive (motivation) mechanism fails to perfectly align Agents’
activities with the organisation’s (the Principal’s) objectives. This is more
likely to occur to the degree to which the organisation faces uncertainties
of one sort or another and, thus, to the allocation of discretion:
a. At one extreme, the manager (Principal) may decentralise
discretion to an Agent, trust the incentive mechanism, and
monitor the output.
b. Alternatively, the manager may centralise the discretion and
issue directives as to the appropriate activity.

A production system can thus be characterised by a number of key variables:

• the degree of environmental uncertainty
• the mix of routinisation and discretion depending on the level of
uncertainty
• the design of the system; determined by P or jointly by P and A
• the incentive mechanism; individual or group/team
• monitoring individual and group
• discretion; centralised with P or decentralised with A
• innovation; centralised with P or joint with P and A.

There are a number of ideal types, such as:

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Abel himself has formulated the following Uncertainty typology in terms of
Principal (P) and Agents (As).

Degree of Type 1: Type 2: Type 3: Type 4:

environmental Low Moderate High Very High
uncertainty Uncertainty Uncertainty Uncertainty Uncertainty
1. Mix of P designs a P designs a P designs P and A jointly
routinisation routinised limited very limited design the
and discretion (rule- routinised routinisation production
intensive) (rule- and the system.
2. Design of production intensive) distribution of
the system system. production discretion
(determined system. (centralised
by P or jointly with P or
by P and A) decentralised
with As).

3. The P contracts with As on an individual incentive P contracts

incentive basis. with As on a
mechanism; team
individual or (economists’
group/team term) or group
basis.

4. Monitoring P monitors the output of As. P monitors P monitors

individuals discretionary group
and group performance. performance.
5. Discretion: Discretion is P centralises Discretion Discretion
centralised low (absent in the discretion. decentralised decentralised
with P or the extreme to As. to the group of
decentralised case). As.
with A

6. Innovation: Innovation is Innovation is determined by P. Innovation

centralised low. jointly
with P or determined by
jointly with P P and As.
and A.

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 EXAMINATION QUESTIONS

B08 / Q3: As uncertainty increases, the

limits of bureaucracy increase. What
implications does this statement have for control
and coordination of activities in firms?

B08 / Q5: Make a case for viewing

Taylorism in terms of a role structure.

AB15 / Q2: How does ‘scientific

management’ address problems of coordination and control in organisations?

2020 / Q2: Tesla Motors is a car manufacturer that uses hundreds of robotic arms to
carry out most of its manufacturing. This enables Tesla to produce different vehicles
at the same time, by supplying the robots with different instructions. How does this
approach compare to that of Scientific Management? What are the comparative
benefits of the two approaches?

2021 / Q2: Launched in 1908, the Ford Model-T was the first affordable car in the
United States. Every vehicle developed at Ford over the following years was then
built around the same basic rolling chassis, whether it was destined to be a coupé or a
tractor. What is the rationale guiding this approach to Ford’s manufacturing process?
How does it relate to the principles of scientific management?

Closing Thot

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 LECTURE 8 / C4: INCENTIVES AND MOTIVATION
Essential reading
D and S Sections 7.1, 7.2, 7.3, 7.6, Chapter 8.
H and B Chap 8

Aim of the chapter

To contrast Principal-Agent theory with other motivational theories.

4.1 INTRODUCTION (CONTRIBUTION OF ECONOMISTS)

It would be difficult to deny that a prime mechanism which provides control

and co-ordination within many organisations is the incentive system.
Individuals and groups carry out activities which contribute to the objectives of
the organisation because they are provided with incentives to do so. These
incentives might be very varied, though, depending upon the factors which
happen to motivate individuals. Economists emphasise financial incentives
whereas psychologists and sociologists try to incorporate a much wider range
of motivations.

All the positions on the market–organisation continuum (→ Chap 1 and 10)

can be viewed as occasioning different types of incentive mechanisms.
a. At one end, perfectly competitive markets offer incentives for a
buyer and seller to trade at an equilibrium price.
b. At the other end, a centralised hierarchical organisation makes
use of the employment contract (usually incomplete), specifying a rate of
remuneration to control and co-ordinate activities.

Some possible remunerations are:

• pay by ‘effort’ exerted; forcing contract (see below)
• pay by results (PBR) or by output
• pay by time – wage rate
• promotion
• prizes for the best performance.

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Economists have developed the most coherent theory of incentives.
Principal–agent (PA) theory is the result.

DEFINITION: In economics (and political science), the problem of motivating

one party to act on behalf of another is known as ‘the principal-agent problem’.
The principal-agent problem arises when a principal compensates an agent
for performing certain acts that are useful to the principal and costly to the
agent, and where there are elements of the performance that are costly to
observe. This is the case to some extent for all contracts that are written in a
world of information asymmetry, uncertainty and risk. Here, principals do not
know enough about whether (or to what extent) a contract has been satisfied.
The solution to this information problem – closely related to the moral hazard
problem – is to ensure the provision of appropriate incentives so agents act in
the way principals wish. In terms of game theory, it involves changing the
rules of the game so that the self-interested rational choices of the agent
coincide with what the principal desires. Even in the limited arena of
employment contracts, the difficulty of doing this in practice is reflected in a
multitude of compensation mechanisms (‘the carrot’) and supervisory
schemes (‘the stick’).

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As D and S make clear, PA theory is very general. It can be applied to any
situation where one or a number of individuals (As) take decisions on behalf
of another individual (the P). PA theory is introduced in terms of the
separation of ownership and control between the owners and managers of an
organisation, and D and S follow this procedure. In fact PA theory grew out of
the debate over ownership and control.

(Note: The theory can equally be applied to the hierarchical relations within
organisations. Indeed a hierarchy can be viewed as a series or cascade of PA
relationships operating down the line. For the moment, though, let us follow D
and S and motivate the general theory in terms of the specific relationship
between owners and managers.)

The possible misalignment of incentives between owners and managers can

be offset by a number of mechanisms:
• stock market prices
• the market for corporate control
• the market for managerial labour
• product market competition.

Each of these markets can impact upon managerial behaviour and militate
against managers pursuing their own objectives. D and S interpret PA theory
as normative – how P and A should behave given appropriate assumptions. It
is, however, often used as a positive theory.

Economists study PA relationships in terms of both rational calculation and

material (financial) incentive/motives. As we shall see later, many other social
scientists are sceptical about either or both of these assumptions, particularly
in a positive sense, but sometimes also in a normative sense.

However, for the moment it is important to understand the basic ideas

behind the theory. Pay particular attention to the role of information – who is
assumed to know what – in the reasoning. Many of the interesting analytic

C4 Incentives and Motivation 97

conclusions arise when information is not symmetric between P and A and
where they have different attitudes to risk (see below).

D and S links incentives into monitoring and bonding. Bonding means that the
manager takes the initiative to bind himself and to be monitored. Bonding is
often also referred to as credible pre-commitment. For example, the manager
takes the initiative to have the company’s books audited or to install a board
of directors. Monitoring means that the outsiders take the initiative. Both
monitoring and bonding are costly; under the assumptions of the model the
manager bears these costs.

The flexibility of PA theory can be seen in the role of fixed wage rate and
payment by result (PBR) in designing optimal incentive contracts. (Appendix
4.1 , which you don’t need to work out the mathematic, demonstrates that
wage rates will arise when an Agent is relatively risk-averse and would
therefore prefer a fixed wage rather than a variable return, such as PBR.

The general lessons are:

• Incentive contracting depends upon the distribution of information

between P and A; in particular, can P observe (monitor) A’s effort or
not? It is always assumed that A can do so.

• Incentive contracts depend upon the risk-bearing attitudes of both P

and A.

• PBR gives full marginal returns to A but also imposes risk on A. Conversely,
a fixed wage rate puts the risk onto P but reduces A’s return.

4.1.1 Assumptions of simple PA models

• P wants to control (i.e. the definition of organisation) A’s activities so that

A’s effort (input) contributes to P’s goals (i.e. the objectives of
the organisation). Putting it another way, P wants to eliminate control

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loss (→ Chap 3).

• Output depends on A’s effort and other random factors (e.g. the
weather in strawberry production).

• A does not like effort (at an increasing marginal rate).

• A has an available alternative (outside) reservation wage (income/utility). A

therefore enters into the contract with P on a voluntary basis. Thus,
for many economists, the contract is not conceived as involving a
coercive power relation operating between P and A (→ Chap 5).

• Alternative information and risk assumptions:

Case (1): P can observe/monitor A’s effort, so can A – symmetric information

Since P can observe A’s effort, P can determine which level of effort from his
own point of view is optimal and give A a forcing contract that obliges A to
choose this level of effort. The forcing contract is then an optimal contract
from P’s point of view.

Case (2): P can’t observe/monitor A’s effort but A can – asymmetric info
There are two reward structures namely a wage contract (fixed salary
independent of payoff, such as an employment contract where P pays A a
fixed wage: A has no incentive) and a rent contract (Rent is not dependent on
payoff: A pays P a rent and therefore has incentive to maximise payoff.)
Under the wage contract, P bears all the risk. Under the rent contract, the
situation is reversed. Thus in both instances (since there is asymmetrical
information), the optimal contracts now depend upon risk assumptions:

a. A is risk neutral (P is risk neutral). In this risk scenario, a

franchising / rent contract is optimal. A, being risk-neutral, does not
demand compensation for risk-bearing since he does not care
about risk. Since risk can be imposed by P on A without cost to P, a
rent contract is the best reward structure for A.

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 b. A is risk-averse (P is risk-neutral). In this risk scenario (a
reasonable assumption in many situations), the optimal contract is risk-
sharing. A will receive a fixed wage component (reservation wage) in
his remuneration. This is because A does not want to bear the risk, like
in a rent contract. P can also offer a contract where A’s income
depends on the payoff.
P must make a trade-off between giving A incentives (More incentives
= Higher payoff) and having A bears more risk (Higher risk by A = More
income by P). Thus, in risk-sharing, A and B both bear an amount of
risk in order to achieve an optimal contract.

A: RISK AVERSE A: RISK NEUTRAL

P: RISK Wage contract (A: No incentives, no Rent Contract (A:
NEUTRAL risks) Maximum incentives,
Reservation wage (More risk = more max risks)
incentives = higher payoff)

Case (3): P cannot observe A’s behaviour directly (asymmetric information)

but P can obtain a signal (eg number of hours he clocked on a job)
concerning the level of effort by A.

Since P can observe a signal (i.e. imperfect or partial monitoring) of A’s effort;
then if, and only if, A is risk-averse, the contract should reflect the signal.
Since A is risk-averse, there is a cost to P letting the agent bear more risk. In
this situation, a reward structure based both upon the signal and the pay-
off is better from P’s point of view than a pure reward structure based only on
the payoff. Otherwise the franchising contract is optimal.

Simple PA models assume that observations, if they can be made, are made
costlessly but are more complicated (realistic models incorporate costs of
observing and drawing conclusions; → Chap 3).

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4.1.2 Extensions of PA theory

D and S identify two important extensions of the basic PA theory.

1. Where one P monitors several independent As. Thus, P has a span of

control over a number of As each operating independently. If the output of the
As are interdependent then we need to think in terms of a span of co-
ordination.

It is further assumed that P knows that the random inputs for each of the
As are identical (this fits the adjacent strawberry plot example rather well but
does not work if the plots are dispersed and experience different climatic
conditions, or problems with farm pests). P can now compare the relative
effort levels of the As to the average level. Above- and below-average
performance can only be attributed to differences in effort level. If P is risk-
neutral and the As are risk-averse, then the optimal incentive contract will be
proportional to (1) individual output and (2) average output.

2. Where there are many periods, such that P repeatedly monitors the
performance of A. Again, if P is risk-neutral and A is risk-averse, then P
contracts upon A’s past performance. If A is also risk-neutral, then a franchise
contract is optimal.

It is the assumptions about risk which make PA theory particularly interesting.

When P contracts with A using a fixed wage rate as opposed to PBR then P is,
in effect, insuring A against fluctuations in A’s remuneration. Indeed, the major
conclusion of the theory is that in the absence of risk aversion on A’s behalf,
the optimal relation is for P to franchise A. Fixed (time) wage rates, which are
often seen as closely allied with organisations, arise because of A’s risk
aversion. Organisations are thus conceived as insurance mechanisms.

Be extremely cautious in applying PA theory to real-world problems.

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C4 Incentives and Motivation 102
The theory furnishes an impressive system of interrelated concepts which is
central to modern organisation theory but at the cost of rather extreme
simplification. You need to match this intellectual elegance with the much less
systematic but empirically detailed approach of sociologists and psychologists.
So let us now turn in that direction.

4.2 THE CONTRIBUTION OF SOCIOLOGISTS AND PSYCHOLOGISTS

Basic PA theory is driven by certain basic assumptions:

• P and A are driven by material incentives / motivations.

• A dislikes exerting effort. P’s effort is not explicitly brought into the
picture, though designing the optimal mix of incentives and
monitoring may be conceived as such.

• The distribution of information (knowledge) between P and A.

• The relative risk attitudes of P and A.

Psychologists and sociologists have made the most significant impact in

terms of:
a. a richer picture of human motivation

b. the origins of differing risk attitudes

c. the impact of groups upon risk taking (→ Chap 5)

d. the demotivating aspects of many types of organisations

(sociologists)

The landmark ‘theories’ are:

• Maslow’s hierarchy
• Herzberg’s theory.
• Equity theory
• Expectancy theory (contrast with economist’s expected utility theory)

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4.2.1 Content theory: Maslow's Hierarchy of needs Theory (1943)

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C4 Incentives and Motivation 105
4.2.2 Content theory: Hertzberg's Motivation - hygiene theory (1959)

C4 Incentives and Motivation 106

Problems with Hertzberg's model:

1. Lack of empirical evidence to support contention that motivators

and hygiene factors are mutually exclusive.

2. Use of biased sample

3. Tendency for informants to blame sources of dissatisfaction on

external conditions and to attribute sources of job satisfaction to their
own personal initiative.

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4.2.3 Content theory: McClelland's Dynamic theory of needs (1961)

C4 Incentives and Motivation 108

4.3.1 Process theory: Equity Theory of Adams (1963)

C4 Incentives and Motivation 109

C4 Incentives and Motivation 110
C4 Incentives and Motivation 111
4.3.2 Process Theory: Vroom's valance, instrumentality and expectancy
theory (1964) (to be contrasted with Expected Utility Theory)

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C4 Incentives and Motivation 113
 Expected Utility Theory (Economics)
Rational actions are motivated by and ends oriented desires. We act in the belief that
our action will further our ends. But more often than not, we must act in the face of
significant uncertainty. This is especially apparent when we recognize that “doing
nothing” often amounts to maintaining the status quo which is itself an action

What should one do when the outcome of a possible action is uncertain? Should one
perform the action or not? You might be inclined to say that in the face of sufficient
uncertainty, one should not act at all. But this strategy can easily turn out to be
irrational (in the means ends sense). Consider the rabbit who opts not to run for the
safety of his hole due to uncertainty over whether or not the noise he just heard in the
bushes was a coyote.

Some degree of uncertainty attends all of our actions. In the realm of business, the
most profitable actions are typically taken with a higher degree of uncertainty. Of
course, the greater the degree of uncertainty attending the profitable outcome of an
action, the greater the risk of an unprofitable outcome. So how does one weigh the
potential risks of an action against its possible costs or benefits in the face of
significant uncertainties.

In order to calculate the expected value of an action we must first distinguish all of its
possible outcomes and assign probabilities and values to each. Often we can't assign
numerical values to the probabilities or values of the outcomes of actions. But we can
illustrate the notion of expected utility with a case where we can assign simple
numerical values to the probabilities and values of the outcomes of a particular
action. Consider the following scenario:

The action you are considering is betting one dollar on getting a six on a single roll of
a fair six sided die. The payoff is $100 if six comes up. Otherwise, you lose your
dollar.

There are only two possible outcomes for this bet. One is that you lose. That
outcome has a negative value of one dollar and a probability of 5/6. The other
possible outcome is that you win. This outcome has a positive utility of $99 ($100
minus the dollar you bet) and a probability of 1/6. Plugging these values into our
formula for calculating expected value yields the following:

(-1)(5/6) + (99)(1/6) = 94/6

So the expected value of taking the bet is 94/6 or about $15.66 expressed in dollars.

We don’t yet know whether or not you should accept the bet. The practically rational
agent will perform the action that has the highest expected value of all available
alternative actions. Whether or not you should accept this bet depends on what other
actions you have the option of taking with your dollar. A bet with a bigger payoff and
or better odds might yield a higher expected value yet. If such a bet is available, a
rational agent (with only one dollar) would pass on the bet we've describe and take the
one with the highest expected utility.

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4.4.1 Comparisons

Each of these theories offers a list of factors which may motivate individuals
within organisations. However, economists argue that the social scientific
support for some aspects of most of them is patchy. Furthermore, they may
also be culturally specific. In organisational theory, we need to ask whether or
not these theories are relevant to organisational design. The social process of
motivating others starts with Taylorism and then introduces some important
distinctions:

• intrinsic and extrinsic rewards

• job enrichment
• job enlargement
• job diagnostic surveys
• empowerment.

You will scarcely be able to avoid contrasting the intellectual styles of PA

and motivation theories. The former is often mathematically rigorous and
highly abstract; the latter is less rigorous but much more detailed and
empirically rich. From an organisation theory standpoint one would expect
organisation design to take account of a richer set of motives than purely
financial ones. They may also vary across individuals, gender, social class,
culture, nationality, etc.

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4.4.2 Incorporating into an extended PA Theory?

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General assessment of motivation theories
1. Strengths
a. Offer managers useful insights in how to understand what motivates
employees and how to raise motivation in practice.

b. Content theories are useful for helping managers understand what

motivates employees.

c. Process theories suggest how motivation occurs and under what

conditions.

2. Weaknesses
a. Culture and gender blind: ideas based on assumptions of middle-class
male American values.

b. Complex link between motivation and performance. Need to account

for ability and opportunity.

C4 Incentives and Motivation 117

It should be possible in principle to incorporate all the various motivating
factors instanced in the above motivational theories into an extended PA

C4 Incentives and Motivation 118

theory. The problem is that it is difficult to actually quantify these effects. If we
ask the question, ‘what, from a PA perspective, is the optimal mix of
empowerment and income?’ the mathematics is easy but the practicalities are
immense. But organisation theorists need to ask such questions.

PLEASE NOTE THAT ASSIGNMENT 1 IS DUE NEXT

LECTURE.
(Model answers only for completed assignments.)

EXAMINATION QUESTIONS

A2/Q6: “The structure and

functioning of most organisations cannot
be understood in terms of material
incentives.” Discuss.

(The answer is in this Chapter, especially

PA Theory. Reference should be made to
all three perspectives mainly in this
Chapter as well as a bit of the next – since
both covered incentives.)

A07/Q6: Show what the optimal contract is between a risk neutral principal and
agent.

(The answer is in this Chapter. In addition, a reference to the arguments, not

necessarily the arithmetic in Appendix 4.1, would be helpful.)

A07/Q11: How far do you agree with this statement:” Human beings are neither
rational nor motivated by material incentive.”

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(The introduction should make reference to rational choice/ PA theory [Chapter 1.1]
and proceed to this Chapter to discuss Content theories [Sect 4.2.1] and Process
[Sect 4.2.2] theories of motivation.)

P09/03: How effective are financial rewards as a means of motivating and

improving the performance of workers? In your answer please draw both on economic
and psychological theories of organisations.

• Define financial rewards and the different forms these can take, for example,
payment by results, performance related pay, team based, share ownership and/or
options.

• Discuss economic theories of reward, in particular, principal-agent theory.

Include the relationship between the effectiveness of reward systems, the design of
contracts and risk bearing attitudes.
.
• Discuss the psychological theories of motivation noting key differences in
assumptions regarding the importance of financial rewards for motivation. Include
both content (Maslow, Hertzberg) and process (equity and expectancy) theories.

• Discuss the possible limitation of the above theories and other factors (such as
national culture) that might shape attitudes towards financial reward.

A15/Q3: What are the differences between content and process theories of motivation?
How do these compare with principal-agent theories of motivation?

2020 / Q3: Uber operates a platform that regulates the transactions between drivers
and passengers. In this setup, Uber is known as the platform provider, Uber’s driver-
partners are the service providers and the passengers are the service buyers. Explain
how the principal-agent theory applies in this context and how risk is distributed
among the actors.

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2021 / Q3: Discuss the relative advantages of analysing organisations as incentive
systems and rule-governed systems.

Closing Thot

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