Why Do Firms Use Incentives That Have
No Incentive Effects?




                 Paul Oyer
                 Stanford Unive...
Incentives

  Almost no incentive system is strictly
  about incentives (on-the-job behavior)
  Incentives affect hiring
 ...
The Power of Incentives

 Sales Commissions
 CEO Pay
 Other examples
   Piece rates in manufacturing
   Windshield Install...
Key Problem #1: Groups

 Software Engineers
 Marketing Managers
 Management Consultants



                          4
Key Problem #2: “Distortion”

  Piece Rates → Quality
  Problems
  Salespeople make promises or
  lower price to meet quot...
Key Problem #3: Risk

 People prefer sure things
 Firms have to compensate for
 risk
 For example, sales
 commissions are ...
Good Incentives

 Based on measures that are closely
 related to things the employee can
 affect
 Closely related to the f...
Why Group Incentive?

 Many “incentives” are at a group level
   Broad-Based stock and option plans
   Profit sharing
   B...
A Simple Example
 A medium/large (several thousand
 employees) Silicon Valley company gives
 stock options to all employee...
Why Use These Incentives?

 Sorting
   Who will accept this compensation?
 Retention
   Flexible compensation costs
   Kee...
Sorting: A Simple Example
 Safelite Glass installs car windshields
 Individual installers do on-site work
 Firm switched f...
Sorting and Group Incentives

 Can this explain broad-based stock
 plans?
 Who is attracted to stock options?
   Optimists...
Retention & Group Incentives

 Think of the new MBA making
 $100K/year
   Option grant of $200K upon taking job
   Options...
Retention

 If Acme did NOT use options, it might
 pay the employee $140K/year
 Costs the firm $5-10K/year to
 compensate ...
Retention

 Options vest over four years.
 Employee is tied to Acme.
 But Acme can make anything vest.
 For example, put s...
Retention

 Because option value fluctuates with 2
 things
   Value of employee to Acme
   Value of the employee to Acme’s...
Retention
 Suppose the economy takes off in the first
 year employee is at Acme
 Stock is up 25%
 Employee gets attractive...
Retention

 Unvested option value tracks her labor
 market value
 Increased temptation to leave
 automatically countered b...
Retention

 What if the economy does poorly in
 that first year?
 Suppose stock price is down 25%
 New engineers now avail...
Retention

 Acme faces cost pressure
 May want to cut wage expenses
 But the market has actually done that
 for them!
 Fir...
When Will This Work?

 Firm-based “incentives” can be
 effective for retention when
   Labor market wages correlated with
...
Why It Works in Silicon Valley

  Fluid labor market – skill is not “firm
  specific”
  Many local employers with similar
...
When Won’t it Work?

 Firms that are unusual in their area
   Coke employees in Silicon Valley
   Microsoft employees in D...
Summary

 Incentives are not just about incentives
 ALL incentives affect selection and
 retention
 Group “incentives” oft...
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Why Firms Use Incentives That Have No Incentive Effects

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Why Firms Use Incentives That Have No Incentive Effects

  1. 1. Why Do Firms Use Incentives That Have No Incentive Effects? Paul Oyer Stanford University Graduate School Of Business 1
  2. 2. Incentives Almost no incentive system is strictly about incentives (on-the-job behavior) Incentives affect hiring And they affect retention In fact, some “incentives” are ONLY about hiring and retention 2
  3. 3. The Power of Incentives Sales Commissions CEO Pay Other examples Piece rates in manufacturing Windshield Installers Tree Planters and Fruit Pickers Common Thread – Tied to Individual Performance 3
  4. 4. Key Problem #1: Groups Software Engineers Marketing Managers Management Consultants 4
  5. 5. Key Problem #2: “Distortion” Piece Rates → Quality Problems Salespeople make promises or lower price to meet quota “Teaching to the Test” Doctors take “easy” cases to improve report cards 5
  6. 6. Key Problem #3: Risk People prefer sure things Firms have to compensate for risk For example, sales commissions are higher in uncertain environments 6
  7. 7. Good Incentives Based on measures that are closely related to things the employee can affect Closely related to the firm’s ultimate goals (cannot be “distorted”) 7
  8. 8. Why Group Incentive? Many “incentives” are at a group level Broad-Based stock and option plans Profit sharing Bonus pools based on firm success While not easily distorted, can employees affect these measures? 8
  9. 9. A Simple Example A medium/large (several thousand employees) Silicon Valley company gives stock options to all employees Let’s call this company “Acme” New MBAs get options worth over $200K If that employee takes an action that increases firm value by $1million, he/she gets $29 Good management would use more efficient means to encourage effort 9
  10. 10. Why Use These Incentives? Sorting Who will accept this compensation? Retention Flexible compensation costs Keeps people when you want them 10
  11. 11. Sorting: A Simple Example Safelite Glass installs car windshields Individual installers do on-site work Firm switched from hourly pay to piece rate; Productivity increased about 40% Half of this was due to people working harder The other half was due to “Sorting” More productive people applied Less productive people left 11
  12. 12. Sorting and Group Incentives Can this explain broad-based stock plans? Who is attracted to stock options? Optimists – Those who believe in company/industry Risk Takers Suckers? 12
  13. 13. Retention & Group Incentives Think of the new MBA making $100K/year Option grant of $200K upon taking job Options vest ¼ per year If Acme stock is flat or down for four years, worth nothing If stock doubles in 4 years, employee nets $500K 13
  14. 14. Retention If Acme did NOT use options, it might pay the employee $140K/year Costs the firm $5-10K/year to compensate employee for risk If options don’t create incentives, what does Acme get for it’s money? 14
  15. 15. Retention Options vest over four years. Employee is tied to Acme. But Acme can make anything vest. For example, put some money in a savings account and give it to employee after 4 years. After all, that’s what pensions are. So why options? 15
  16. 16. Retention Because option value fluctuates with 2 things Value of employee to Acme Value of the employee to Acme’s competition 16
  17. 17. Retention Suppose the economy takes off in the first year employee is at Acme Stock is up 25% Employee gets attractive and tempting offers She can realize about $30K if she leaves But, even if stock is flat for the next three years, she leaves $100K “on the table” Also, she gives up $270K of “option value” 17
  18. 18. Retention Unvested option value tracks her labor market value Increased temptation to leave automatically countered by increased incentive to stay 18
  19. 19. Retention What if the economy does poorly in that first year? Suppose stock price is down 25% New engineers now available for $125K in cash and options She isn’t receiving attractive offers 19
  20. 20. Retention Acme faces cost pressure May want to cut wage expenses But the market has actually done that for them! Firm paying below current market wage Employee lost half her option value Firm avoids layoffs and pay cuts! 20
  21. 21. When Will This Work? Firm-based “incentives” can be effective for retention when Labor market wages correlated with firm’s stock price Workers are not too risk averse Changing jobs is easy for employees but costly for firms 21
  22. 22. Why It Works in Silicon Valley Fluid labor market – skill is not “firm specific” Many local employers with similar needs Firms’ fortunes (and wage offers) rise and fall together 22
  23. 23. When Won’t it Work? Firms that are unusual in their area Coke employees in Silicon Valley Microsoft employees in Dayton When many workers are risk averse (for example, big mortgages) When workers are already tied to the firm 23
  24. 24. Summary Incentives are not just about incentives ALL incentives affect selection and retention Group “incentives” often are ONLY for selection and retention Choose any incentive plan wisely – tie measures to employee “inputs” 24

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