Economics of Human Resources Management

In this lecture, Holmstrom criticallyIn this lecture, Holmstrom critically evaluates the Pay for performance incentive system and concludes that pay for performance isn’t easy to execute. Also, it is more suitable for industries and jobs where success can be easily quantified like salesperson, production industry.

Pay for performance is also related to bring market inside the firm. Which means that employees with in the firm are competitors and will fight among each other to get maximum out of the company’s limited resources. Holmstrom argues this model and writes in the paper based on his experience working on incentive problems for 25 years, that within frms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the frm are generally misguided. Typically, it is best to avoid high-powered incentives and sometimes not use pay for performance at all.

The principal agent problem

Principal-agent problem is one of the reason why pay for performance is complicated. Generally, you define principal as employer and agent as employee. For example, if you take service from lawyer then you would be principal and lawyer would be agent. Most of the time, principal and agent have different motives. Contracts can be difficult because their preferences aren’t aligned and agent performance is imperfectly measured. If principal cannot measure performance of agent perfectly then pay for performance will induce risk on the agent and since the agent wants to avoid risk as much as possible, there is a trade-off between risk and incentive.

Generally, this problem is addressed by introducing linear bonus for performance in addition to fixed wage. But, problem with using a linear function is that then answer won’t tell us why different incentives are used in different contexts. Also, it doesn’t tell us about trade-offs which are the causes of incentive problem.

While designing a contract between principal and agent there are two constraints. One is that agent should get at least his reservation utility if chose the contract and second is that it should also motivate him to act as the principal wants.

Holmstrom introduced this principle, which states that an ideal contract should factor any available measures of performance by the agent in calculating the compensation. Which means it should also factor relative performance to other similar agents to remove the luck factor.

To understand this, one can use the example of manager whose actions influence his company’s share price but not share prices of other firms. Should a manager’s pay depend only on her firm’s share price? No: Because share prices reflect other factors in the economy outside the manager’s control, only linking compensation to the firm’s share price will reward the manager for good luck but punish him for bad luck. It’s preferable to link the

Essay – Pay for Performance and beyond, M.A. in HRM& LR,TISS -Mumbai

Shrutam Shailesh Jani (M2018HRM052)

manager’s pay to his firm’s share price relative to those of similar firms and not just on the share price she can work to control.

Similarly, CEOs should not be allowed to enjoy windfall gains from favourable macroeconomic conditions. Appealing to the informativeness principle, Holmstrom advocate the use of relative performance evaluation as a way to filter out luck.

So, the industries where it is harder to measure effort of agent, the less pay should be paid based on performance.

Multitasking

Sometimes, agent’s job consist of many tasks and it is important for principal to get agent allocate his effort across tasks in a manner that aligns with the pricipal’s objectives. This could be challenging when easy-to-measure and hard-to-measure activities compete for the agent’s attention.

For example, performance of teacher could be evaluated based on the marks of student as well as on the curricular best practices where later one is hard to measure. So, if teachers’ salaries decided mainly on quantifiable results, like test scores, teachers might spend too little time teaching more qualitative skills, like creativity. Hence, a fixed salary, independent of performance measures, would lead to a more balanced effort.

Some tasks are easy to measure where others are hard so one should be careful while designing contract. Holmstrom gives example of Wells Fargo, were employees manufactured fake bank accounts to get bonuses because contract was based on the quantifiable outcome which was no. of accounts created.

We can learn following lessons from multitasking:

• Don’t incentivize competing tasks. To properly provide incentives, pay more for an important task or pay less for competing tasks. When a task is hard to measure, low or no incentives might be best.
• Firms should find substitutes for pay-for-performance incentives. Examples could be the ability to control work through job assignments, job designs and a variety of implicit and explicit rules that the firm sets.
• We can bifurcate task into two tasks and allot those to two different agent. Where one would take task which is easily measurable and that task will be provided with high performance incentives and second agent would take task which is innovative and is hard to measure and that task would have low performance incentive.

Conclusion

The firms should have been careful while designing employee incentive models and pay for performance might not be always suitable because it is more suited to stable industries and jobs where success can be easily quantified.

Also, informativeness principle suggests that an contract should link payment to all outcomes that can potentially provide information about actions that have been taken. Means, it should not only depend on variables agent can control but should be a form of relative performance evaluation. In Short, There’s a lot beyond pay for performance. evaluates the Pay for performance incentive system and concludes that pay for performance isn’t easy to execute. Also, it is more suitable for industries and jobs where success can be easily quantified like salesperson, production industry.

Pay for performance is also related to bring market inside the firm. Which means that employees with in the firm are competitors and will fight among each other to get maximum out of the company’s limited resources. Holmstrom argues this model and writes in the paper based on his experience working on incentive problems for 25 years, that within frms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the frm are generally misguided. Typically, it is best to avoid high-powered incentives and sometimes not use pay for performance at all.

Principal-agent problem is one of the reason why pay for performance is complicated. Generally, you define principal as employer and agent as employee. For example, if you take service from lawyer then you would be principal and lawyer would be agent. Most of the time, principal and agent have different motives. Contracts can be difficult because their preferences aren’t aligned and agent performance is imperfectly measured. If principal cannot measure performance of agent perfectly then pay for performance will induce risk on the agent and since the agent wants to avoid risk as much as possible, there is a trade-off between risk and incentive.

Generally, this problem is addressed by introducing linear bonus for performance in addition to fixed wage. But, problem with using a linear function is that then answer won’t tell us why different incentives are used in different contexts. Also, it doesn’t tell us about trade-offs which are the causes of incentive problem.

While designing a contract between principal and agent there are two constraints. One is that agent should get at least his reservation utility if chose the contract and second is that it should also motivate him to act as the principal wants.

The informativeness principle

Holmstrom introduced this principle, which states that an ideal contract should factor any available measures of performance by the agent in calculating the compensation. Which means it should also factor relative performance to other similar agents to remove the luck factor.

To understand this, one can use the example of manager whose actions influence his company’s share price but not share prices of other firms. Should a manager’s pay depend only on her firm’s share price? No: Because share prices reflect other factors in the economy outside the manager’s control, only linking compensation to the firm’s share price will reward the manager for good luck but punish him for bad luck. It’s preferable to link the

Essay – Pay for Performance and beyond, M.A. in HRM& LR,TISS -Mumbai

Shrutam Shailesh Jani (M2018HRM052)

manager’s pay to his firm’s share price relative to those of similar firms and not just on the share price she can work to control.

Similarly, CEOs should not be allowed to enjoy windfall gains from favourable macroeconomic conditions. Appealing to the informativeness principle, Holmstrom advocate the use of relative performance evaluation as a way to filter out luck.

So, the industries where it is harder to measure effort of agent, the less pay should be paid based on performance.

Multitasking

Sometimes, agent’s job consist of many tasks and it is important for principal to get agent allocate his effort across tasks in a manner that aligns with the pricipal’s objectives. This could be challenging when easy-to-measure and hard-to-measure activities compete for the agent’s attention.

For example, performance of teacher could be evaluated based on the marks of student as well as on the curricular best practices where later one is hard to measure. So, if teachers’ salaries decided mainly on quantifiable results, like test scores, teachers might spend too little time teaching more qualitative skills, like creativity. Hence, a fixed salary, independent of performance measures, would lead to a more balanced effort.

Some tasks are easy to measure where others are hard so one should be careful while designing contract. Holmstrom gives example of Wells Fargo, were employees manufactured fake bank accounts to get bonuses because contract was based on the quantifiable outcome which was no. of accounts created.

We can learn following lessons from multitasking:

• Don’t incentivize competing tasks. To properly provide incentives, pay more for an important task or pay less for competing tasks. When a task is hard to measure, low or no incentives might be best.
• Firms should find substitutes for pay-for-performance incentives. Examples could be the ability to control work through job assignments, job designs and a variety of implicit and explicit rules that the firm sets.
• We can bifurcate task into two tasks and allot those to two different agent. Where one would take task which is easily measurable and that task will be provided with high performance incentives and second agent would take task which is innovative and is hard to measure and that task would have low performance incentive.

The firms should have been careful while designing employee incentive models and pay for performance might not be always suitable because it is more suited to stable industries and jobs where success can be easily quantified.

Also, informativeness principle suggests that an contract should link payment to all outcomes that can potentially provide information about actions that have been taken. Means, it should not only depend on variables agent can control but should be a form of relative performance evaluation. In Short, There’s a lot beyond pay for performance.