BSZ_IM_Ch15_4e - Managerial Economics and Organizational...

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Managerial Economics and Organizational Architecture Instructor’s Manual Part 1: Chapter Overview and Solutions Chapter 15: Page 1 CHAPTER 15 I NCENTIVE C OMPENSATION This chapter is the second of two chapters on compensation policy (reward system). It provides a detailed examination of incentive compensation. It begins by highlighting the basic tradeoff between optimal risk sharing and incentives. The standard principal-agent model is presented in non-technical terms. This basic model is extended to analyze other issues concerning incentive compensation. The debate over whether incentive pay works is discussed. A case study on CEO pay is presented. The appendix examines multitask principal-agent theory in more detail. C HAPTER O UTLINE T HE B ASIC I NCENTIVE P ROBLEM Incentives from Ownership Optimal Risk Sharing E FFECTIVE I NCENTIVE C ONTRACTS Principal-Agent Model Informativeness Principle Group Incentive Pay Multitasking Forms of Incentive Pay Incentive Compensation and Information Revelation Selection Effects of Incentive Contracts D OES I NCENTIVE P AY W ORK ? C ASE S TUDY : T HE D EBATE OVER CEO C OMPENSATION S UMMARY A PPENDIX : M ULTITASKING T HEORY T EACHING THE C HAPTER We begin by providing an overview of the major topics in the chapter and emphasize the basic tradeoff between risk and incentives in considering the level of incentive pay. Factors favoring high incentive pay are discussed. Typically we begin the discussion by asking the students whether they would prefer a job that paid $100,000 fixed salary or one that paid a 10 percent sales commission which in good years paid $150,000, and in bad years $50,000. Although the expected compensation is the same (probability in good years is .5), most would prefer the fixed salary. This moves into a discussion of compensating differentials for risk. We
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Managerial Economics and Organizational Architecture Instructor’s Manual Part 1: Chapter Overview and Solutions Chapter 15: Page 2 sometimes review a homework problem on this topic. We discuss the benefits of incentive pay (getting people to work harder). Occasionally we review homework problems that emphasize the incentives of ownership. Next we provide a detailed example of the tradeoffs in choosing the level of incentive pay. Eastman Kodak recently shifted from annual cost-of-living raises to annual performance-based bonuses. In introducing the plan a Kodak spokesman indicated: It is a significant step toward fostering the kind of performance-based culture that is needed to meet the competitive challenges in our industry and in the more difficult competitive market place. A Kodak employee was quoted as saying: Many employees are upset that they can no longer count on certain wage increases, making budgeting for major household purchases more difficult. The spokesman’s quote emphasizes the incentive effects of the plan, while the
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This note was uploaded on 04/27/2010 for the course FIN 320f taught by Professor Toprac during the Spring '08 term at University of Texas at Austin.

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BSZ_IM_Ch15_4e - Managerial Economics and Organizational...

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