Performance ImplicitContract_6

Performance ImplicitContract_6 - The Principal-Agent...

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1 Performance Incentives Ch 11 pp. 353-372, 376-380 The Principal-Agent Problem When one party pays another party to perform an action, the former party is known as the principal and the latter is known as the agent. A contract is subject to the principal-agent problem when both of the following are true. 1. The action of the agent is not observable, observable only after some period of time or costly for the principal to observe. 2. The action benefits the principal, but is costly to the agent. The principal-agent problem occurs because the incentives of the agent are not in line with the desires of the principal. Principal-Agent Example Example: You hire a real estate agent to sell your home. – You are the principal. – The real estate agent is the agent. You want to maximize the sale price of your home. The real estate agent also benefits from increasing the sale price of your home, but it is costly for the real estate agent to leave your home on the market because time spent on your home takes away from other sales. Principal-Agent Example Suppose you receive an offer of $200,000 for your home. Your agent believes that if you leave the house on the market for two more weeks you would probably receive an offer of $210,000. If the agent receives a 3% commission, the extra two weeks of work would result in $300 of additional revenue, which is not worth it for him/her. So the agent advises you to sell at $200,000 even though it is not in your best interest. Steven Levitt, Freakonomics, finds that on average real estate agents leave their own homes on the market for 9.5 days longer than homes they sell for clients. Labor Contracts The labor contract is another example of the principal- agent problem. – The firm is the principal. – The worker is the agent. Effort by the worker increases productivity and the profits of the firm, but it may be costly to the worker. Performance incentives are designed to increase the effort level of the workers. In other words, performance incentives attempt to align the incentives of the worker with the goals of the firm. Effort and Shirking Assumption: Effort is costly to the worker. – The worker is utility maximizing. Increasing the effort of the worker, holding all else constant, will decrease the utility of the worker. Shirking occurs when a worker exerts an effort level that is less than some expectation. – Examples: taking a nap, playing computer games, emailing friends, reading the newspaper, shopping for a car online.
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2 Performance Incentives Compensation schemes with performance incentives are designed to increase worker effort. Compensation schemes vary across three dimensions: 1. The basis on which pay is calculated. 2.
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Performance ImplicitContract_6 - The Principal-Agent...

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