Managerial Economics Fall 2017 - Mike Shor - PowerPoint Presentation

1. Managerial EconomicsFall 2017 - Mike Shor Lecture 13

2. Last time…2Anticipate adverse selection (never expect “average”)Anticipate moral hazard (incentives change behavior)

3. If a research facility puts in routine effort, your project has a 60% chance of success.If a research facility puts in high effort, your project has an 80% chance of success.If a project succeeds, it is worth $600,000.If it fails, it is worth $0.Each facility has a cost for undertaking the project which depends on its effort: Cost of routine effort: $100,000Cost of high effort: $150,000You own a smaller pharmaceutical company. You subcontract out a large number of research projects (each with uncertain outcome) to outside R&D facilities.Each research facility, once hired, can choose to put in either routine effort or high effort.You do not observe the effort directly.How should you compensate the facilities?Subcontracting3

4. Outline…4Incentive ConflictsPrinciple-Agent RelationshipsChallenges of Incentive Pay

5. I like work.It fascinates me.I can sit and look at it for hours.- Jerome Klapka Jerome

6. Incentives/Information Tradeoff6Who is making the bad decision? Centralized: move decision-making UP to where the incentives are better Decentralized: move decision-making DOWN to where the information is betterDo they have sufficient information? Centralized: transfer informationDo they have sufficient incentives? Decentralized: strengthen incentive compensation

7. Principal Agent Relationships7A principal wants an agent to act on her behalf. Agents often have different goals than do principals. Agency costs: Costs associated with adverse selection and moral hazard in these contextsCan reduce costs by gathering information (e.g., monitoring, but this has costs) or aligning incentives (by shifting risk, but this has costs)

8. Incentive Pay 8Suppose effort can not be observedIncentive-compatible compensation Compensation contract must rely on something that can be directly observed and verified.Related probabilistically to effort E.g., project’s success or failure Imperfect but positive information

9. 9$50The (charity) Roulette Wheel

10. Incentive Pay 10Consider this from subcontractor’s perspective What if it puts in high effort? What if it puts in routine effort?

11. Incentive Pay 11Bonus must guarantee that Marginal benefit of effort > marginal cost of effortBonus depends on difference between low and high effort costs impact effort has on chance of success

12. Challenges12GroupsBehavioralLeakagesRisk

13. Group incentives A 19th century English traveler on a Chinese ferry was shocked at the ferocity with which an overseer whipped the oarsmen.

14. Behavioral ConcernsA new test for a horrible, painful, terminal diseaseRare: one in a million people Accurate test: 95% correct 5% false positive/negativeYou test positive! How worried are you?

15. You can’t just tell people that you value them, you have to show them.You can’t just show people that you value them, you have to tell them.

16. What if incentives are tied to: Revenue? Market share? In many industries, CEO salaries rising, even when underperforming Compensation based on performance declining Why? Improvement over last year’s performance? Quantity produced? 16LeakagesWorkers fired after hang-up calls August 27, 2007Nationwide Mutual Insurance has fired five Iowa workers who routinely hung up on policyholders trying to file claims with the company.Gillum testified that she hung up on policyholders to boost her job-performance statistics.

17. RiskIncentive pay implies employees assuming risk for events out of their control.Employees must be sufficiently compensated for this risk