ECO 610-401

– Organizational Design: Centralized vs.

Decentralized
 Issues in Compensation
• Form of Compensation
– Salary vs. Commission
• Why choose one form over another?
• What determines the mix
– Incentive Compensation
• Compensation and Training
– Does Training (Education) do something other than
or addition to increasing productivity?
– Job Market Signaling
• Level of Pay
– Are there situations when it makes sense to overpay?
– Efficiency Wage
The Principal-Agent Model and Incentive Pay

• Basic Idea: Worker (Agent) produces an output and is

paid by Boss (Principal) who sells it.
• Output depends on agent’s effort and other factors.
• Agent knows effort but boss does not know (because of
other factors)
• How does boss get the agent to exert the right amount
of effort?
– What is the “right” amount of effort?
• Basic Structure of Pay:
– Salary (F)
– Commission (α)
 Incentive Compensation: An Example
• Q = δe + ε
– Q: Output
– e: Effort
– ε: Random component
• Owner’s Profits:
– Π = Q – W = δe + ε – W
• W – Compensation (wage) to agent
• Compensation:
– W = F + αQ = F + α(δe + ε)
• Disutility from Effort:
– C(e) = e2
 Incentive Compensation: An Example
(continued)
• Let δ = $100 so Q = 100e + ε
• Let F = $1,000, α = .2
• Alternative Utility (Wage – Disutility) = 1,100
 Effort with F= $1000 & a = .2

6000
Costs
5500 Output
5000 Wage
4500 Utility

4000 Profit

3500

3000

2500
$

2000

1500

1000

500

0
0 5 10 15 20 25 30 35 40 45 50 55 60
-500

-1000

-1500
Effort
 Effort with F= -$475 & a = .5

6000
Costs
5500
Output
5000 Wage
4500 Utility

4000 Profit

3500

3000

2500
$

2000

1500

1000

500

0
0 5 10 15 20 25 30 35 40 45 50 55 60
-500

-1000

-1500
Effort
 Effort with F= -$1400 & a = 1

6000
Costs
5500
Output
5000 Wage

4500 Utility
Profit
4000

3500

3000

2500
$

2000

1500

1000

500

0
0 5 10 15 20 25 30 35 40 45 50 55 60
-500

-1000

-1500
Effort
 What’s the optimal contract?

• Sell the firm to agent (franchise)

• Why?
– Agent only picks optimal effort when getting the full
gain of efforts
– Optimal Effort = ΔQ/Δe = ΔCost/Δe
– What happens when commission isn’t 100%
– Agent sets effort so that:
– ΔQ/Δe >α(ΔQ/Δe) = ΔCost/Δe
 Optimal Contract

• Why isn’t everyone on 100% commission?

• Answer:
– Risk aversion
– Agent can’t control everything that determines output
so even if the agent puts in the optimal effort, output
still may vary
 Risk & Pay

• Another issue is the role of risk

– Output is not entirely determined by agent’s efforts –
other factors affect it:
• Downturns in market/economy
• Adverse production conditions & increased costs
– Agent wishes to avoid risk (risk averse)
– Boss could simply have 100% commission (franchise)
but:
• This puts 100% of risk on agent
• Boss will have to compensate agent for risk
 Uncertainty and Utility
• In most individuals view there is a difference between:
– 100% (certainty) of receiving $1,000
– 50% of receiving $200 and 50% of receiving $1800
• even though the expected payoff is $1,000 in both cases

• Risk averse individuals will take less of the certain

(<$1,000) over the gamble
• Risk loving individuals will require more of the certain
(>$1,000)
 Risk Aversion
1200

1100

1000

900

800

700
Utility

600

500

400

300

200

100

0
0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000
Income
 Risk Loving
1000
950
900
850
800
750
700
650
600
550
Utility

500
450
400
350
300
250
200
150
100
50
0
0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000
Incom e
 Incentive Compensation with Risk:
An Example
An Example: The High-End Clothing Salesperson
• Sales depends on effort and a random component
– Sales = $100e + ε
• σ2 – Variance in output
– Salesperson is Risk Averse – more risk in earnings, lower utility.
Certainty equivalent is:
– E(Wage) – (1/2)ρV(Wage)
• ρ – extent of risk aversion
• Salesperson doesn’t like effort
• Disutility of Effort: (e-40)2 for e > 40
• Alternative Wage (next best) with certain wage and no effort:
$1,000
 Incentive Compensation with Risk: An
Example (continued)
• The Contract:
– F – Base pay (salary)
– α – Commission
• Certainty Equivalent (CE) for Employee:
– F + α(100e) – (1/2)(e-40)2 – (1/2)ρα2σ2
• Firm must set F & α so that CE > 1000
• Firm maximizes “Expected” Profits by choosing F & α :
• Π = (1-α)(100e) - F
Commissi Effort Effort Risk Expected Salary Revenue Profit
on Level Cost Premium Commissi
on
0% 40 0 0 0 1000 4000 3000

10 50 50 150 500 700 5000 3800

20 60 200 600 1200 600 6000 4200

25 65 312.5 937.5 1625 625 6500 4250

30 70 450 1350 2100 700 7000 4200

 Factors Favoring Higher Pay

1. Output is more sensitive to agent’s effort

2. Level of risk and uncertainty in output beyond agent’s
control is low.
3. Agent is less risk averse
4. Employee responds to incentives more (cost of effort is
lower).
5. Employee’s output can be measured at low cost
 Why and When to Monitor

• Issues:
– Cost of monitoring
– Quality of Signal
• How much information does it provide?
– Distortions in effort and production
 Job Market Signaling

• Why might Wall Street firms hire

physicists?
• Why take courses in advanced
mathematics that are not applied?
• Why tuition differentials that don’t seem to
reflect differences in what is being taught?
 Job Market Signaling

• Firms hire employees without full

knowledge of their abilities.
• A bad hire may be costly for a number of
reasons including: expensive training and
a long period of time before maximum
productivity is reached.
• Hence the firm wants to get as much
information about the ability of potential
employees as possible.
• The extreme case for signaling suggests that education
does not affect the productivity of labor at all ‑‑we don't
learn a thing in school.
• However, success in school is positively correlated with
success in the work force.
– For example, obtaining a high school degree requires
attendence at school and completion of assigned
tasks.
– These attributes are also valued in the workplace and
hence a high school diploma signals that the
employee is likely to have good attendance and
complete assigned tasks.
 Signaling – A Simple Model
• 2 types of workers: High productivity (H) and Low
productivity (L)
• In industry A these workers have different abilities:
– MRPH = $40,000; training cost = $3,000; net
productivity = $37,000
– MRPL = $40,000 training cost = $6,000; net
productivity = $24,000
‑‑Supply: 1,000 of H and 3,000 of L
• In alternative industry (industry O) both types of
workers have same productivity and receive a salary of
$15,000.
• Demand for workers in industry A is made up of demand
from many firms.
 Perfect Information
• If types could be distinguished from each other:
– L receive $15,000 and work in both A and O
– H receive $15,000 + ($37,000‑$24,000) = $28,000 and work in
A (difference in productivity)
• L cannot receive more than $15,000 in A because L's in O will
always be willing to work for $15,000 forcing salaries to be equal.
• H must be paid a premium equal to the difference in productivity
($37,000‑$24,000=$13,000).
• If H is paid $30,000 no firms would hire H and all hire L because
difference in salary>difference in productivity. If H is paid $25,000
no firms would hire L and all bid for H because difference in
salary<difference in productivity, so difference in salaries must
equal difference in productivity.
= $37,000 ‑ $28,000 = $9,000
 No Information
• All paid $15,000 because you can't tell low from
high and if paid more than $15,000 someone from
industry O will work in A for $15,000.

• Expected Profit=
• P(type H)(Net Productivity of H) + P(type L)(Net
Productivity of L) ‑ Salary
= (1/4)($37,000) + (3/4)($24,000) ‑ $15,000
=$12,500
 Imperfect Information

• Suppose that an MBA can be obtained but probability of

succeeding depended on whether type H or L (firms
don't know this).
• H has P(MBA/H) = 9/10 (90% chance of getting MBA
and
• L has P(MBA/L) = 2/10.
 Baye’s Theorem

• What is the probability that someone getting an MBA is

High Ability?
• Use Baye’s Theorem:

P( H ) P( MBA / H ) (1 / 4)9 / 10

P( H / MBA)    3/ 5
P(H)P(MBA/H)  P(L)P(MBA/L) (1 / 4)9 / 10  (3 / 4)(2 / 10)
• Then P(L/MBA) = 2/5
• 60% of MBA’s are high ability versus 25% of population
 Profits and Salary (1)

Expected Payoff from MBA =

P(H/MBA)(Net Productivity of H) + P(L/MBA)(Net
Productivity of L) from MBA ‑ Salary of MBA
= (3/5)($37,000) + (2/5)($24,000) ‑ Salary of MBA
= $31,800 ‑ Salary of MBA
 Profits & Salary (2)
• For Non-MBA Holder:
– P(H/no MBA) = 1/25 and P(L/no MBA) = 24/25.

• Expected Profit =
• P(H/no MBA)(Net Productivity of H) + P(L/no MBA)(Net Productivity
of L) from no MBA‑ Salary of no MBA
= (1/25)($37,000) + (24/25)($24,000) ‑ Salary of no MBA
= $24,520 ‑ Salary of no MBA
Salaries
• No MBA can't get more than $15,000 since that is salary in
alternative.
• MBA gets $15,000 + (difference in expected productivity)
= $15,000 + ($31,800‑$24,520) = $22,280
• Profit
Expected Profit = $31,800 ‑ $22,280 = $9,520
 Costly Education
Intuition:
• If education is costless then everyone will try to obtain a degree
and the higher salary.
• But if costly it won't pay off for someone with little chance of
getting a degree.
• In this case type L won't try to get a degree so that only type H do
improving the signal and therefore increasing the MBA salary.

How much we charge to get perfect sorting?

– With perfect sorting P(H/MBA) = 1 so

Salary MBA = $28,000. C = cost of MBA

• Then if P(MBA/L)(Salary MBA) + P(No MBA/L)(Salary without MBA)
‑ C < Salary without MBA
• (2/10)($28,000) ) (8/10)($15,000) ‑ C < $15,000
• Type L won't pursue an MBA. Solving for C gives $2,600. If tuition
is $2,600 then only type H will get degree.
 Empirical Evidence

A. Weiss, "High School Graduation, Performance, and

Wages" JPE August 1988