3. 1. Incentive Problem
Coordination and Motivation Problem
Task
Coordination Motivation
Who does what, Individual How do I get somebody
when,... to perfom a task,
improve the quality,...
Allocation of Input Distribution of
=> Incentive Problem
Resources Output
Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51
PLWS Theory 3
4. 1. Incentive Problem
Why do Incentive Problems Exist?
Why do Incentive problems exist?
• Employee and employer have different interests
– Employer would want the employee to take actions that maximize
the profit of the firms, but the employee might rather like spending
his time with his/her family or play golf
– All actions of the employee cannot be monitored and/or controlled
by contracts (risk for the employer)
– Employers have to compensate employees for doing undesirable
tasks
PLWS Theory 4
5. 1. Incentive Problem
How can Incentive Problems be Solved?
• Incentive Problems can be solved through effective compensation
contracts
• Compensation contracts have two functions
– Motivate employees
– Share risk more efficiently
Source: www.euro.fi
PLWS Theory 5
7. 2. Compensation Contracts
Payment by Input versus Payment by Output
Variable Pay Straight Salary
(payment by output) (payment by input)
• Compensation depends on measure • Compensation depends on the amount
of what comes out of time or effort spent on an activity
• Amount of time spent on work does • Independent of output consideration
not affect workers‘ compensation
Problem:
Problem: ⇒ Input also not always easy to measure
⇒ Output not always easy to measure • Time at work as a proxy in order to
assess worker‘s effort
Examples: Examples:
• Agricultural workers: piece rates p. tray • Wage per work hour
• A salesperson on straight commission • Monthly salaries
• Compensation of top executives by • Annual salaries
stocks or stock options
PLWS Theory 7
8. 2. Compensation Contracts
How can the Performance of an Employee be
Measured?
•Objective Performance Measure:
– Measure that is easily observable and quantifiable, e.g. parts
produced, hours worked etc.
•Subjective Performance Measures:
– An evaluation which is based on personal opinion of a supervisor,
customer, peers, etc.
Type of evaluat.
objective subjective
Database
Output revenue, dividend customer satisfaction
Input time qualification
PLWS Theory 8
9. 2. Compensation Contracts
Examples of Different Variables as a
Basis of Output-Related Pay
Basis Variables for output-based pay
Quantity of production pieces, weight, size/height
Rejects, grade, customer‘s satisfaction,
Quality of production
individual targets
Reduction of input factors: raw material,
Input reduction
energy, work time
Capacity utilization slack-, repair- and waiting periods
Timeliness vis à vis internal and external
Be on schedule
customers
Value of the firm stock price, economic value added
PLWS Theory 9
10. 3. Output-Based Pay
Advantages of output-based pay
Selection effect Motivation effect
• efficient workers with a high
• output-based pay motivates workers
productivity will join the firm/stay to put forth more effort
• inefficient workers with a low
productivity will not join/leave the firm
Source: www.kone.fi
PLWS Theory 10
11. 3. Output-Based Pay
Selection Effect: An Example of
Compensating Salespeople
World Book Britannica
Offered compensation scheme variable pay: W = $ 100 . fixed salary: W = $ 500
Labor costs of 10 sets; Cost per x
$ 1,000 ⇒ $ 100 per set $ 500 ⇒ $ 50 per set
set type of salesperson
What high productive sp. low productive sp.
will stay with the firm? x ≥ 5 x ≤ 5
Labor costs of 3 sets; Cost per set $ 300 ⇒ $ 100 per set $ 500 ⇒ $ 166,67 per
set
PLWS Theory 11
12. 3. Output-Based Pay
Selection Effect: An Example of
Compensating Salespeople (cont.)
W ...Weekly A (World Book)
Pay
500 B (Britannica)
300
3 5 x ... Number of
encyclopedia
⇒ Higher-productivity workers will leave Britannica,
because they will earn more at World Book. Only lower-productivity workers will
stay at Britannica
PLWS Theory 12
13. 3. Output-Based Pay
Disadvantages of Output-Based Pay
• Disadvantage of piecework: Variations of output can be beyond the worker‘s control
Variable pay Straight salary
• Variable pay depends on invested effort • Fixed salary doesn‘t depend on exoge-
and exogenous risks – risky form of nous factors – low-risk form of
compensation compensation
⇒ Firm should smooth out exogenous risks ⇒ Workers are insured against volatilities
from workers‘ compensation ⇒ Firm provides the insurance for risks
⇒ Firm should bear exogenous risks but
endogenous risks should remain with
workers
• Trade-off: More risk⇔higher compensation • Lower compensation level
• Opportunity: participate in good economic • Can not participate in good economic
development development
• Stronger incentives • Weaker incentives
PLWS Theory 13
14. 3. Output-Based Pay
Risk in Output-Based Pay
• The firm should bear the largest portion of risk because of risk pooling
abilities
• Workers with a high average compensation should bear more risks than
workers with a low average compensation.
Source: www.kone.fi
PLWS Theory 14
15. 4. Input-Based Pay
• In spite of all the advantages of output-based schemes: A large
proportion of workforce is paid by input
• Compensation depends on the amount of time or effort spent on an
activity
• Independent of output consideration
⇒ Time at work as a proxy to assess worker‘s effort
Source: www.euro.fi
Examples: wage per work hour, monthly salaries, annual salaries
PLWS Theory 15
16. 4. Input-Based Pay
Benefits of Input-Based Pay
Problems of output-based pay solved by time-based (input-based) pay
• Finding the right output measure
• Costs of measurement
• Overemphasizing quantity, reduction of quality
• Risk aversion of workers
• Promoting long-run performance
However, in many cases output-based schemes could be used if only they
were designed correctly!
PLWS Theory 16
17. Compensation Schemes
Balancing Quantity and Quality
• Piece rates could induce workers to focus on high numbers of low quality
products meeting only the sufficient quality level to ‚count‘
⇒ Appropriate compensation schemes could solve this problem
Example: Typist‘s compensation
Errors p. page Price p. page Minutes p. page Revenue per hour
0 $8 20 $ 24
1 $7 15 $ 28
2 $5 12 $ 25
3 $3 10 $ 18
4 $0 9 $0
5 $0 8 $0
PLWS Theory 17
18. 4. Input-Based Pay
Using the Appropriate Time Unit
Input-based pay
Hourly wages Monthly salary Annual salary
• Production workers • Managerial workers • Top Management
• Clerical workers
Tasks: experienced and Tasks: less experienced and Tasks: not experienced and
easy to prescribe not easy to prescribe difficult to prescribe; often
to be defined by top manager
• High correlation between • Low correlation between • Undefined set of tasks (goal),
effort and time invested effort and work time discretion over work
• Time input as a pretty • Time input = bad measure for • Importance of other incen-
good indicator for effort effort ⇒ overinvestment in tives to motivate for effort
easy (pleasant) tasks (long-term, e.g. stock options)
PLWS Theory 18
19. 5. Incentive Pay
Optimal Level of Variable Pay
• Since employees do not diversify their risk
– Large exogenous risks should be born by owners
Fixed salary
• However, employees are motivated by pay for performance
Variable Pay
Part of the pay should be fixed and part variable
PLWS Theory 19
20. 5. Incentive Pay
Forms of Incentive Pay
• Rewards do not need to be monetary, they can consist of anything that
employees value
• E.g
Piece rates and commissions Housing
Bonuses Education for kids
Parking spots Retirement Plan
Days off Party
Promotion
Training
Stock ownership
Health care plan
PLWS Theory 20
21. 5. Incentive Pay
Criticism to Incentive Compensation
• Often heard critics to incentive compensation:
– Money does not motivate
– It is difficult to design effective incentive schemes
• Incentives certainly entail costs
• The major problem is to design incentive schemes where the benefits
exceed the costs
PLWS Theory 21