Why Firms Use Incentives That Have No Incentive Effects
Why Do Firms Use Incentives That Have
No Incentive Effects?
Graduate School Of Business
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
The Power of Incentives
Piece rates in manufacturing
Tree Planters and Fruit Pickers
Common Thread – Tied to Individual
Key Problem #1: Groups
Key Problem #2: “Distortion”
Piece Rates → Quality
Salespeople make promises or
lower price to meet quota
“Teaching to the Test”
Doctors take “easy” cases to
improve report cards
Key Problem #3: Risk
People prefer sure things
Firms have to compensate for
For example, sales
commissions are higher in
Based on measures that are closely
related to things the employee can
Closely related to the firm’s ultimate
goals (cannot be “distorted”)
Why Group Incentive?
Many “incentives” are at a group level
Broad-Based stock and option plans
Bonus pools based on firm success
While not easily distorted, can
employees affect these measures?
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
Good management would use more efficient
means to encourage effort
Why Use These Incentives?
Who will accept this compensation?
Flexible compensation costs
Keeps people when you want them
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
The other half was due to “Sorting”
More productive people applied
Less productive people left
Sorting and Group Incentives
Can this explain broad-based stock
Who is attracted to stock options?
Optimists – Those who believe in
Retention & Group Incentives
Think of the new MBA making
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
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?
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?
Because option value fluctuates with 2
Value of employee to Acme
Value of the employee to Acme’s
Suppose the economy takes off in the first
year employee is at Acme
Stock is up 25%
Employee gets attractive and tempting
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”
Unvested option value tracks her labor
Increased temptation to leave
automatically countered by increased
incentive to stay
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
Acme faces cost pressure
May want to cut wage expenses
But the market has actually done that
Firm paying below current market
Employee lost half her option value
Firm avoids layoffs and pay cuts!
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
Why It Works in Silicon Valley
Fluid labor market – skill is not “firm
Many local employers with similar
Firms’ fortunes (and wage offers) rise
and fall together
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
Incentives are not just about incentives
ALL incentives affect selection and
Group “incentives” often are ONLY for
selection and retention
Choose any incentive plan wisely – tie
measures to employee “inputs”