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underlines the binary choi

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Joined 2016-06-14

Misalignment of incentives usually comes down to a problem of workers choosing to do the \wrong\ thing. The variations on the basic model of agency illustrate many of these problems:

1 – When workers have several tasks to perform , incentive systems have a hard time getting the balance right. Attention and effort will be given to those activities on which the employee perceives that he or she can have the biggest impact in terms of compensation. The perception of a large impact, in turn, depends on two considerations: Does the reward system take significant account of this or that measure of performance? And how much control does the individual have over the performance measures – how noisy is the relationship between efforts and performance measures?

Incentive systems typically are keyed to tasks that are measured easily and relatively noiselessly; things that are harder to measure are given short shrift because they are hard to measure well. But no matter what the reason, if a task is not formally recognized in a worker\s incentive pay, he or she has less incentive to pay attention to that task. This problem can be particularly vicious in service industries where it is hard to monitor the quality of service given; service can suffer, unless the server is motivated by tip income or (more effectively) by the desire to build a personal client who will reward the server with repeat business.

2 – Misalignment also results from dynamic effects: For several reasons – administrative cost, to provide reasonable measures of performance along some dimensions, and to keep the scheme from consuming workers\ attention review periods may be kept fairly long. But then workers have the incentive to play games with the review system, as a review deadline approaches.

3 – And , comparative evaluation or tournament schemes can cause substantial misalignment: Employees have some motivation either to hurt the efforts of co-workers, to engage in undue conformity, or to collide among themselves against the employer.

But misalignment isn\t simply a matter of value-neutral responses to a given set of economic incentives. When a firm engages in pay for performance, it is signaling to employees – perhaps unintentionally, but nonetheless what it seemingly wants. When the organization explicitly rewards efforts at task A, it is sending a fairly strong signal that tasks Band C, not explicitly rewarded, are less important. When it rewards quantity, it is signaling that quality is less important. When it makes compensation more salient , it signals that \pushing the envelope\ to get more compensation is okay. Let us be clear here: Most management that engages in pay for performance would be aghast at the suggestion that they are sending these signals. But in at least some external environments, those signals are going to be received, whether or not they were intentionally sent.

Tournaments can promote unhealthy rivalry, undesirable conformity, or worker attempts to collide against the employer. (When the comparative evaluation is done relative to an external benchmark, the problem of conformity remains, but the other two problems are usually largely absent.)Tournaments and benchmarking schemes will be viewed as inequitable if they don\t take into account uncontrollable factors that lead to differences in performance outcomes. But efforts to surmount those difficulties through elaborate subjectively determined handicapping schemes are often rife with politicking and viewed as illegitimate on those grounds. And schemes that base rewards on improvements in individual performance raise the specter of the ratchet effect and the corresponding individual response to seek short-term improvements and then depart.

Legitimacy is a potential concern not only with schemes that employ comparative evaluation, but whenever a scheme either doesn\t take account of special circumstances or does so subjectively. The standard story here concerns rewarding division managers in a large corporation based on how well their divisions do. Imagine such a scheme being used by a firm with an important division that is in trouble. Top management may want to send one of their most talented managers to tackle the problems facing this division. But is the manager to be rewarded:

1) Strictly on the basis of how the division does, making it a very unattractive assignment , at least for a while;

2) On a subjectively \adjusted\ basis, sparking cries of favoritism and encouraging politicking; or

3) based on \objective\ improvements in performance, which gives the division head an incentive to find quick fixes that are motivated by the formula more than by concern for the long-term problems of the division and then to move on to another division or job, before the quick fixes become problems?

The argument that pay-for-performance systems can be inflexible begins with the obvious observation that such systems rarely are perfectly tuned to their environment.