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Safelite Auto (B)

Incentive Compensation
Chapter 15
In-Class Principal-Agent Incentive Model

In-Class Student Presentations
Safelite Glass
Did PPP succeed?
What were the problems with PPP?
Should management proceed with the
introduction of PPP or even a modified PPP?
What were the consequences of the switch
from wage rates to piece rates for:
Turnover
Recruitment
Productivity
Product Quality
Total Labor Costs
Safelite Glass
600 small auto-glass repair centers
1994 pay for performance introduced
Hourly wages = f(base salary, glass installed)
Minimum base salary = $11/hr
Must install defectives without pay
Benefits
36% increase in installed glass/day
Improved productivity per worker
Better workers stay
Decrease in turnover
Costs
Operating: 9% increase in pay/employee
Investment: not high; info system could handle
Net effect
Increase in profits
Source: E. Lazear, Performance Pay and Productivity, The
American Economic Review, Dec. 2000

Basic principal-agent model
Effort not directly observable use proxy
post contractual asymmetric information
Outside risk factor
Could work hard but not all measured
=> Compensation contract
tie incentive pay to proxy to motivate effort
Include base pay to reduce risk bearing
Basic principal-agent model
Workers output: Q=e+, ~(0,
2
)
output depends on effort and a random element
Profit=(e+)-W
profit is output minus cost of worker
Comp. Contract: W=W
0
+Q, 0 1
compensation has a fixed component and an element
linked to output
Solution
Firm sets W
o
and b
Worker maximizes E(U)=E(W-e
2
)
Worker chooses effort
e* = ab/2
Effort increases with b
Basic principal-agent model
Risk
If replace some base pay with variable
compensation
More variability in pay; increased risk
Must give higher expected compensation
(compensating differential)

Compensating Differential for Bearing
Risk: 3 Jobs
$100,000 with 100% certainty

0 50% of the time
$200,000 50% of the time

50,000 50% of the time
$150,000 50% of the time
Specific principal-agent model
a=$100
u=+$800 with probability 0.50;
-$800 with probability 0.50;
=0.2
W
0
=$800
Q=e+
W=W
0
+Q, 0 1
Estimating unknown productivity

Choosing incentive pay rate requires firm to
know productivity (a)
E.g. choose b to elicit effort since e*=ab/2
Time and motion studies
dysfunctional behavior
Past performance
ratchet effect
Lincoln Electrics Concern about the ratchet
effect
Measurement costs
Measurement of evaluation criteria is costly
Accounting system
Data entry time & personnel
Supervisor observation
Record keeping
Accuracy check
Training
Opportunism
Gaming
Unethical efforts to alter performance
measurements (e.g. Q)
Unintended consequences
I.e. the typist at Lincoln Electric
Evaluation system should be set up to detect
&/or reduce the likelihood of opportunism
Subjective performance evaluation
Why? Some tasks difficult to measure but
should be rewarded
Subjective evaluation methods
Standard rating scales
Goal-based systems
Problems
Supervisor shirking
forced distribution
influence costs
Navy Officer Evaluation System
Relative performance evaluation
Measures performance relative to other
employees or other firms
E.g. 20% commission on individual sales over
average for department
E.g. Bonus earned if market share increases are
higher than competitors
Benefits
Can lower compensating differential by sifting
out outside effects (m) from effort
Alternative: use subjective component to
adjust for outside effects
Elicits high competitiveness
Relative performance evaluation
Costs
dysfunctional competitiveness
jobs not always identical
data across firms hard to obtain
group has incentive to punish rate busters
incentive to hire less competent workers
Combining performance measures
Few job performance measures are purely
objective or subjective
Both types can be inaccurate
increasing inaccuracy of either places greater
weight on other
inaccuracies increase employee risk
Both can induce dysfunctional behaviors
Looking Forward
December 6, 7, or 9: Performance Evaluation
Chapters 16 and 17
Prepare Arthur Anderson Case (ch. 17)
Course Project Due

December 13, 14, or 16: Final Exam
Blackboard: Past Exam Exams
Open book, open notes
Remember to bring a calculator and all course
materials