AN OVERVIEW OF COMPENSATION METHODS USED TO SUBVERT THE PRINCIPAL-AGENT PROBLEM

1. AN OVERVIEW OF
COMPENSATION METHODS
USED TO SUBVERT THE
PRINCIPAL-AGENT PROBLEM
THE WAYS
WE GET PAID
Slides by Amanda Silver

2. WHAT IS THE PRINCIPAL-
AGENT PROBLEM?
This dilemma in economics is said to occur when an agent is contracted to
take actions on behalf of the principal, but the two parties have different
interests.
Business owner = PRINCIPAL Employee = AGENT
Interests:
Profits
Share price
Growth
Interests:
Personal earnings
Stable employment

3. WHAT IS THE PRINCIPAL-
AGENT PROBLEM?
Although there might be some alignment of values or goals between the
principal and the agent, it is the principal that shares in the outcome. When
an agent makes risky decisions because it is the principal that will have to
reap the consequences, this is called a moral hazard.
Contracts are designed to set terms that align interests of both parties,
relying heavily on incentives and performance-based rewards.

4. The nature of the job
The extent to which workers have
discretion in their jobs
The extent to which output is
objectively and viably measurable
The extent to which the measures
used to pay workers truly reflect the
inputs of effort
1.
2.
3.
4.
FACTORS THAT IMPACT THE
EFFECTS OF PAY STRUCTURES

5. COMPENSATION MECHANISMS
TO ALIGN INTERESTS IN THE
WORKPLACE
Annual salary
Gainsharing
Time work
Commission
Gratuities
Piece work
Tournament
Deferred compensation
Note: some compensation mechanisms have overlap and may be used in combination

6. A salary is a fixed rate paid at regular intervals.
Because it is fixed, employers are not required to
pay overtime for additional hours or output.
As the process of mass production gained favor
over craft production, we saw an emergence of a
class of salaried executives and administrators,
tasked with monitoring and managing their
growing labor force.
Salaries are set by looking at the market
comparisons, supply of people available to
perform a job, and negotiation. It is commonly
used in a knowledge work economy, where
output is difficult to measure objectively.
ANNUAL SALARY
accuracy to
performance
reliability for
worker
ease of
administration
Starting rate is influenced by the
individual's skill in negotiation,
which is different from their skill in
performing the job
Rates only change through
promotion or at the subjective
discretion of a manager

7. Gainsharing systems are designed to give
employees a stake in the collective performance
improvements of a company.
In the mid 1900s, Joseph Scanlon popularized a
gainsharing system called the Scanlon Plan, in
which workers were engaged in designing their
own reward system based on company
performance.
Gainsharing can apply to a large range of
incentive systems, including profit sharing,
Employee Stock Ownership Plans, and worker
ownership.
GAINSHARING
accuracy to
performance
reliability for
worker
ease of
administration
This system directly rewards
collective performance, but not
necessarily individual merit
These programs can be difficult to
implement, and their effect is
greatly contingent on market
factors

8. Time work is wages earned based on hours
worked. This type of work is usually associated
with shift work and part-time work.
This system does require overtime payment if
work hours exceed 40 hours in one week.
Hourly workers are often susceptible to irregular
scheduling and variable hours. When workers do
not control their schedules and shift hours, it can
lead to family-conflict and other health risks.
TIME WORK
accuracy to
performance
reliability for
worker
ease of
administration
For the 17 percent of the workforce
with unstable work shift schedules,
wage can vary greatly week to week
Because wage rate is pre-set,
quality of performance or output is
not recognized through this system

9. IN 2018, VARIABLE PAY
BUDGETS DROPPED BY THE
LARGEST MARGIN SINCE 2010
The Aon U.S. Salary Increase Survey notes that
businesses expect to be paying their employees more
overall, indicating that companies are reserving more
funds for higher starting salaries, but reducing the use
of bonuses and incentive pay.

10. A commission is a form of variable-pay designed
to motivate workers to achieve certain
measurable outcomes, most commonly sales.
Commissions are usually paid on top of a base
salary, based on a preset terms.
Managers have discretion when designing the
terms of a commission plan, and can include
different frameworks such as team-based,
quotas, and tiers.
COMMISSION
accuracy to
performance
reliability for
worker
ease of
administration
Depending on how much a worker
earns with their base-pay, there can
be huge variability in income based
on performance and market factors

11. Gratuity is an additional sum of money, usually
percentage of the cost of service, paid by the
customer to the service provider, usually on top
of a sub-minimum wage ($2.13 federally).
Tipping became a common practice in 17th
century England, where overnight guests were
expected to pay a "vail" to their host's servants.
The practice of tipping has prevailed in the
service industry in the United States, as its
believed to provide an incentive for good service,
but it is often criticized for being arbitrary and
susceptible to discriminatory biases.
GRATUITIES
accuracy to
performance
reliability for
worker
ease of
administration
The size of the bill is the main
determining factor of the tip, not
the quality of the service
Other associated problems include
sexual harassment and racial
stereotyping

12. Piece work is a system in which the worker is paid
based on output, regardless of time spent.
This system originated in the guild system, when
craftworkers would be paid based on pieces
produced. Today, piece work can refer to
products assembled/produced or projects/tasks
completed.
Piece work has transitioned into the digital age in
the form of call centers (pay per call), and micro-
tasks like Amazon's Mechanical Turk.
PIECE WORK
accuracy to
performance
reliability for
worker
ease of
administration
The system can accurately reward
volume of work, but often leads to
issues with quality of output
The wage a worker can earn is
susceptible to fluctuations in
demand, making the work
precarious

13. PROBLEMS WITH INCENTIVE PROGRAMS
TEMPORARY
COMPLIANCE
DYSFUNCTIONAL
BEHAVIORS
ERODE
PSYCHOSOCIAL
COMPENSATION
Once the reward is achieved,
people return to their
previous behaviors.
Agents will emphasize the
behavior that is rewarded,
even if these behaviors are
only a subset of the work.
"Measuring software productivity by
lines of code is like measuring progress
on an airplane by how much it weighs."-
Bill Gates
Some psychologists argue
that performance-pay can
have negative impact on
instrinsic motivation.

14. Tournament compensation rewards individuals
based on how they do relative to others. In other
words, this is a zero-sum game in which
individuals are incentivized to compete.
Tournaments reward risk-seeking behavior, which
can reduce cooperation and lead to potentially
negative outputs for the whole.
This model might be used to determine bonuses,
promotions, or determine the entire wage of a
contracted worker.
TOURNAMENT
accuracy to
performance
reliability for
worker
ease of
administration
Tournament-style payment is
common in the production of broiler
chickens, with problematic
consequences
Farmers are supplied feed and
chicks, and paid based on outcome.
If they are given bad feed or sick
chickens, they earn the worst rate

15. Deferred compensation is a seniority wage
system in which younger workers are "underpaid"
and older workers are "overpaid."
This mechanism can be used to encourage loyalty
and tenure. Employees with the company for
longer can be considered for higher pay brackets,
through or independent of promotion, and access
increased benefits like pensions or stock options.
DEFERRED
COMPENSATION
accuracy to
performance
reliability for
worker
ease of
administration
Seniority and experience are not
always a good indicator of output
Such systems purposefully
undervalue the merit of younger
workers
Such programs can also be examples of, "golden
handcuffs" in which employees financial benefits
are structured to discourage them from leaving.

16. PAYCHECKS ARE
JUST PART OF THE
STORY
COMPENSATION =
WAGES + BENEFITS
Vacation time
Health care
Child care
Retirement benefits

17. PAYCHECKS ARE
JUST PART OF THE
STORY
Contingent workers, domestic
workers, and agricultural
workers are excluded from
certain worker protections and
federal minimum wage
requirements