Transcript Confronting Moral Hazard: Economic Incentives

Confronting Moral Hazard:
Economic Incentives
Ignore other incentives?
•Pride
•Opinion of peers
•The general good
•Ethical considerations
Adam Smith
•Theory of Moral Sentiments, 1759
•Wealth of Nations, 1776
Ethics before self-interest
Motivating the Salesman
Find profit maximizing incentive scheme
For risk averse salesman,
U(W,B,X) = (W+B)1/2 - X
W = guaranteed wage; B = bonus; X = exertion
X
P = Probability of sale
0
5%
10
25%
20
40%
40
50%
Gross profit from sale = $60,000
Expected net profit = P x ($60,000 – W – B) - (1 – P) x W
Expected salesman compensation = P x (W + B) + (1 – P) x W
Salesman expected utility = Px{(W+B)1/2 - X} + (1 – P)x(W1/2 - X)
EU ≥ 100 = salesman’s expected utility in alternative occupation
Insights from Heuristic Search
• Wage – bonus tradeoff for risk averse salesman
– For same expected compensation paid by firm,
salesman is happier when more comes via
guaranteed wage and less comes from risky bonus
– But “efficient” risk – sharing, where risk-neutral firm
bears the risk, annihilates motivation
For given level of effort, firm should raise wage
and lower bonus, keeping salesman’s expected
utility constant but reducing the expected total
compensation paid to the salesman … up to
point where his exertion drops.
Extending the Incentive Model
• Continuous effort
• Continuous probability of success
• Continuous earnings from sale
Salesman risk aversion: is less better than more?
• Less averse: more likely to work hard for prize
• But can’t cut expected bonus a lot by increasing
guaranteed wage a little … with EU constant
Salesman effort aversion: less beats more
• Should lazier salesman get stronger incentive?
Incentives and “noise”: outcomes depend on other
things besides salesman exertion
– Impact on profits
– Impact on exertion
Incentive schemes
… and their discontents
• Comparative evaluation (control for
environmental factors employee can’t influence)
– Collusion
– Destructive competition
• Tournaments … the pot of gold
– Low performers don’t bother
– So high performers don’t hustle
• Quotas / handicaps
– Slow down now so look good later
• Ignore hard – to – measure performance
– Get lousy non-monitored performance