402 • Chapter 12 • Performance Measurement and Incentives

THE PRINCIPAL–AGENT RELATIONSHIP

A principal–agent relationship or agency relationship occurs when one party (the agent) is hired by another (the principal) to take actions or make decisions that affect the payoff to the principal.2 As one example, consider the relation between a public firm’s shareholders (the “principal”) and its chief executive officer (CEO) (their agent). The CEO’s job description usually includes strategic planning, hiring operating officers, and managing the organization. If the CEO manages and plans effectively, the firm’s share price will rise and shareholders will be paid larger dividends. If the CEO does a poor job running the firm, the return to shareholders will suffer.

The principal–agent framework is broadly applicable. All of a firm’s employees can be thought of as agents of the firm’s owners, since they all take actions or make decisions that might impact the payoff to the owners. The principal–agent framework can also be used to think about relationships between firms, between professionals and their clients, or even outside of the business world entirely. Advertising agencies act as agents for consumer product companies, doctors act as agents for their patients, and elected officials are expected to act as agents on behalf of voters.

Difficulties in agency relationships can arise when two conditions are met: (1) The objectives of principal and agent are different, and (2) the actions taken by the agent or the information possessed by the agent are hard to observe. We discuss each condition in turn.

The typical principal would like to maximize the difference between the value it receives as a result of the agent’s actions and any payment it makes to the agent. If the agent had the same objective, we would say that the goals of the principal and agent were aligned. But the agent does not directly care about the value generated for the principal; the agent cares about the value it generates for itself. Their interests are normally not aligned. Legal scholar Adolf Berle and economist Gardiner Means were among the first to describe the differences in objectives in the shareholder–CEO agency relationship.3 One important objective of a firm’s shareholders, they wrote, is to “earn the maximum profit compatible with a reasonable degree of risk.” The objectives of management are often harder to discern. Managers may wish to maximize their personal wealth even if shareholders do not benefit. Managers may wish to limit their personal risk, avoiding risky strategic initiatives that shareholders view as “reasonable.” Managers may wish to boost their prospects for another job, and could therefore take actions that pump up the firm’s short-run performance even if shareholders are harmed in the long run. Finally, managers could simply be averse to excessive effort—putting in a series of 80-hour weeks doing strategic planning is, after all, very hard work.

Differences in objectives are not by themselves sufficient to lead to problems in agency relationships. If actions and information are easily observable, then the principal can write a complete contract with the agent that aligns their interests. We discussed complete contracts in Chapter 3, where we identified several reasons why it is difficult to write them. In particular, contracting can be hindered by hidden action or hidden information, things known to the agent but not to the principal. When the principal and agent have different objectives, and the agent can take hidden actions or has hidden information, agency problems can arise.

Combating Agency Problems

One way to mitigate hidden action and hidden information problems is to expend resources watching employees or gathering information that employees use to make

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EXAMPLE 12.1 DIFFERENCES IN OBJECTIVES IN AGENCY RELATIONSHIPS:

YAHOO! AND ENGLISH FRUIT

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decisions. For example, one important role of corporate boards of directors is to monitor the decisions of the firm’s CEO. Directors are usually themselves current and former top executives at other firms, which can make them skillful monitors of other CEOs. Directors meet regularly and often spend time talking to a firm’s employees, suppliers, and customers. They review financial statements, reports, and investment decisions, and they frequently vote to approve or disapprove major decisions made by the CEO, such as undertaking a large acquisition.

While monitoring can help firms resolve problems of hidden action and information, it does have some significant limitations. First, it is often imperfect. While most members of corporate boards are business experts with years of experience, they typically do not spend more than about 25 days per year on company business. Given the complexity of many large, modern organizations, it is difficult to imagine that directors could digest all information that is relevant for CEO decision making. Second, hiring monitors can be quite costly. Members of corporate boards are paid large retainers (frequently in excess of $250,000 annually). Similarly, general counsels at large corporations earn salaries that can approach a million dollars per year. Even in lower level jobs where managers who monitor employees earn a fraction of the salary paid to a director, such as assembly lines, call centers, and retail sales, these costs can be substantial. Third, hiring a monitor often introduces another layer to the agency relationship. Adding a board of directors may help solve agency conflicts between the shareholders and the CEO, but shareholders may then have to worry about agency conflicts between themselves and the directors.

When principals cannot adequately monitor their agents’ actions, or find it excessively costly to do so, they may prefer to tie pay directly to performance.

PERFORMANCE-BASED INCENTIVES

Using pay-for-performance incentives can mitigate agency conflicts by aligning the interests of the agent and the principal. To do this, the principal links the agent’s pay (or, more generally, the value the agent receives) to the payoff the principal receives from the agent’s action. The agent earns more when the principal does well and less when the principal does badly, and so is more willing to take actions that benefit the principal.

Performance-based incentives are everywhere. Salespeople at department stores like Nordstrom and Galleries Lafayette receive commissions equal to approximately 5 percent of their customers’ purchases. Brand managers at consumer goods firms like Kraft or Maruchan typically receive year-end bonuses that are linked to the profit

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generated by their brands. Most publicly traded firms grant stock and stock options to chief executive officers, thereby linking CEO wealth to the return that shareholders earn. Firms can also offer nonmonetary rewards—“employee of the month” parking, vacations for top sales agents, and “status” rewards such as plaques and special mention at company events.

The best way to explain the properties of performance-based incentives is with a simple economic model of how a hypothetical employee may respond to such incentives. We will use this model to consider more complex aspects of incentives, so pay careful attention to the notation. Consider a firm that hires an employee to perform a sales function. Let the employee’s effort level be represented by e. Think of units of effort as “hours during which the employee puts forth high effort.” We make this distinction because the principal may be able to observe the number of hours that the employee works, but is unlikely to observe the number of hours during which the employee puts forth high effort. Thus, e represents a hidden action and cannot be included in a contract.

Now suppose that the employee is willing to put forth some high effort regardless of compensation, but will exert extra effort only if compensated in some way. One way to represent this is to write the employee’s cost of exerting effort level e in monetary terms. Specifically, let the cost of exerting effort level e be given by the following formula, which is also depicted in Figure 12.1:

The interpretation of this function is as follows. The employee is willing to increase effort from e0 to e1 if and only if the additional compensation (whether monetary or nonmonetary) is at least c(e1) 2 c(e0). The flat region on the curve in Figure 12. 1 indicates that the employee is willing to put in up to 40 units of effort for no extra compensation. However, the employee is willing to exert additional effort beyond 40 units only if compensated for doing so. The cost function is convex, indicating that extra effort becomes more and more costly as the employee’s effort level increases.

Now consider an employee who puts in 40 units of effort and is considering putting in one additional unit of effort. According to the preceding formula, the effort costs the employee c(41) 2 c(40) 5 $0.50. Suppose that each unit of effort generates $100 in extra sales to the principal. Thus, sales 5 $100e. Hence, one additional unit

FIGURE 12.1

A Convex Cost of Effort Function

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of effort generates a net surplus of $99.50 for the two parties—the $100 in extra sales captured by the firm less the $0.50 in effort cost borne by the employee. How can the firm get the employee to make the extra effort? If effort were observable, the firm could simply offer to pay the employee an additional $0.50 for the extra unit of effort. As noted earlier, it might not be possible for the firm to observe whether the employee is putting in extra effort, so this offer is not feasible.

Let us consider some compensation schemes that are feasible. Suppose that the firm pays the employee a straight salary that matches the market wage, which we assume is $1,000 per week. The employee’s payoff net of effort costs is $1,000 2 c(e). Given that pay does not depend on sales, the employee in this case is unwilling to put in more than 40 units of effort. Phrased another way, if the employee has nothing to gain from extra effort, then no extra effort should be expected. The employee’s 40 units of effort result in $4,000 in sales, while the wage paid is $1,000. The firm earns $3,000 in profits.

Suppose instead that the firm offers a salary of $1,000 per week, but adds a 10 percent commission on sales. Given that each unit of effort produces an extra $100 of sales, we can write the employee’s payoff as

$1,000 1 0.10(100e) 2 c(e)

The employee will increase effort until the marginal benefit of effort is equal to the marginal cost. As shown in Figure 12.2, the marginal benefit of effort to the employee is always 10 percent of $100, or $10—each unit of effort translates into another $10 in commission. The marginal cost of effort is the slope of the effort curve. The convex shape of this curve implies that it becomes more and more costly for the employee to exert additional effort. A bit of calculus shows that the employee is best off choosing e 5 50; at any effort beyond this, the marginal cost of effort exceeds the marginal

FIGURE 12.2

The Employee Increases Effort Until the Marginal Benefit of

Effort Is Equal to the Marginal Cost

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benefit.5 When e 5 50, we can calculate the following: total sales are $5,000, the employee’s commission is $500, and total cash compensation is $1,500. The employee’s compensation, net of effort costs, is $1,500 2 0.5(50 2 40)2 5 $1,450, and the firm realizes profits of $5,000 2 $1,500 5 $3,500. Compared with straight salary plan, we see that the increase in wages paid by the firm under the salary-plus-commission plan is more than offset by the increase in the employee’s productivity. Both the firm and its employee are better off.

The firm may be able to achieve even higher profits by slightly adjusting the salary-plus-commission plan. Under the current plan, the employee has net compensation of $1,450, which is $450 more than the market wage. The employee should therefore be willing to accept a contract that offers up to $450 less than the current plan; put another way, the employee should agree to a plan that pays at least $550 plus 10 percent commission. The employee would still put in 50 hours of extra effort and would earn $1,000 in net compensation, just enough to prefer this job to another one at $1,000. The firm would see its profits increase from $3,500 to $3,950.

This example illustrates several key points about performance-based incentives:

1.The slope of the relationship between pay and performance, rather than the absolute pay level, provides incentives for effort. As Figures 12.2 and 12.3 illustrate, raising the employee’s salary (say, from $900 to $1,000) does not change the cost-benefit trade-off determining the employee’s effort choice.

2.The firm earns a higher profit when it offers the salary-plus-commission job than with a fixed salary job.

3.The firm can do even better if it sets a higher commission rate. In fact, the firm’s profit-maximizing commission rate is 100 percent! (That is, the worker keeps all the sales revenues.) Why? The firm would like to maximize total value, which is the difference between total revenues and worker costs. This occurs if the worker

FIGURE 12.3

The Firm Can Offer a Lower Salary without Changing Incentives for Effort

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EXAMPLE 12.2 HIDDEN ACTION AND HIDDEN INFORMATION IN GARMENT

FACTORY FIRE INSURANCE