Incentives & Control

Question

What great document was written in 1776?

Question

Why are some countries rich and some poor?

AnswerThe specialization of labor…

The Specialization of Labor Do one task, do it well Smith talked about movement away from self

sufficient farms to urban model of specialized craftsman

Later taken to the extreme in Scientific Management

M. Hammer (1996) “When I tell people what I do for a living, I tell them that I am reversing the Industrial Revolution”

Industrial Revolution

The widespread replacement of manual labor by machines that began in Britain in the 18th century and is still continuing in some parts of the world. The Industrial Revolution was the result of many fundamental, interrelated changes that transformed agricultural economies into industrial ones. The most immediate changes were in the nature of production. Goods that had traditionally been made in the home or in small workshops began to be manufactured in the factory. Productivity and technical efficiency grew dramatically, in part through the systematic application of scientific and practical knowledge to the manufacturing process. Efficiency was also enhanced when large groups of business enterprises were located within a limited area. The Industrial Revolution led to the growth of cities as people moved from rural areas into urban communities in search of work.

Taylor, F. (1929) The Principles of Scientific Management

Based on the idea that one can apply engineering principles to manage labor inputs in optimal fashion

Exemplified by Ford’s assembly line Work is disaggregated (each worker

performs a single motion). Work is simple, repetitive, routine, and highly structured; it requires low level of skill and judgment.

Tools: standards, statistics, mangers, formal reporting and coordination mechanisms

Taylorism

Develop a "science" for every job, including rules motion, standardized work implements, and proper working conditions.

Carefully select workers with the right abilities for the job.

Carefully train these workers to do the job, and give them proper incentives to cooperate with the job science.

Support these workers by planning their work and by smoothing the way as they go about their jobs.

Hawthorn Studies (Human Relations) organizations are social systems, not just technical economic systems we are motivated by many needs we are not always logical we are interdependent; our behavior is often shaped by the social context informal work group is a major factor in determining attitudes and

performance of individual workers management is only one factor affecting behavior; the informal group often

has a stronger impact job roles are more complex than job descriptions would suggest; people act

in many ways not covered by job descriptions there is no automatic correlation between individual and organizational

needs communication channels cover both logical/economic aspects of an

organization and feelings of people teamwork is essential for cooperation and sound technical decisions leadership should be modified to include concepts of human relations job satisfaction will lead to higher job productivity management requires effective social skills, not just technical skills

The Professional Manager

Berle, A.A. and G.C. Means (1932) The Modern Corporation and Private Property

Large companies are no longer run by the people that own them – isn’t this a problem???

Yes….Leads to Agency Conflicts

Potential Locations of Agency

Stockholders Board of Directors Senior management Middle managers Line employees Customers

CSS

CRM

SFA

Agency Sources

1. Potential divergence of interest2. Basis of gainful exchange or

transaction3. Difficulties in monitoring and

enforcing4. You do not bear the full consequences

of your actions

Solutions

Internal• Improve monitoring• Explicit incentive contracts. Linking pay to some operational

output – bonuses, options.• Achieving goal congruence – equity positions• Peer Approval• Signalling!!!!

External• Competing sources of information• Monitoring by markets (takeovers)• Sources of social governance eg. reputation, peer approval,

morals, religion, culture

Labor Markets

Primary: Internal labor markets, insulated from free market mechanisms of secondary markets. Incentives via opportunity of promotion.

Secondary: Skills paid at market rate, often hourly basis.

eLance economy? Are the boundaries between primary and secondary markets dissolving?

Promotions as Tournaments Require only ordinal information about who did better

rather than cardinal of absolute performance data Relative performance evaluation controls for the

exogenous factors that affect all individuals Bonus pool set in advance, employer has no reason

to misrepresent employee's performance to safe on performance bonus payments

Mitigates the need to bargain individually with employees over salary

Negative correlation between open position and salary differentials

Tenure & Partnership up or out low level jobs continuously turned over fresh ideas and outside perspectives close evaluation of outside candidates incentives to hold junior people down as

source of rents destroys incentives and ruins recruiting

Recent tendency of Big 3 extending equity positions down to lower levels… Why?

Property Rights

Why are some countries rich and some poor? D. North

"Economic growth will occur if property rights make it worthwhile to undertake socially productive activity".

Property rights should be clearly assigned, secure and transferable. (Pollution caused by the absence of well defined property rights – negative externality)

High complementarily + high specificity + uncertainty monitoring difficulty= integration

Equity & Partnershipcomplementary assets should be owned by the same

agent where complete contracts are impossible.

“People are our greatest resource”

Human knowledge can be bounded, socially embedded, tacit, context dependant, idiosyncratic, inalienable, sticky…

= complementary assets cannot be owned by single agent

Incentive Misalignment/Agency

Compensation Policy

Deal with uncertainties in earnings opportunities Signal what organization values and what

behavior and attitudes it wants to discourage Help employees decide how to allocate their time

and effort among competing ends Reward accomplishments/success and failures Provide motivation for behavior which contributes

to organizational success Meet employees needs for material consumption,

equity, status

Piece Rate

Some studies have indicated that productivity increases of 15-35% with implementation of piece rate.

Strong motivators Elicit self-selection Easily understood

Piece Rate Disadvantages

Variance in relationship between output and effort required

Exogenous, random variables can affect worker income

May contradict logic of assembly line production models

Encourages employees to ignore other valuable activities for company, unlikely to help or cooperate other employees

Group Incentives

Determining individual performance may be impossible

Groups have better information about contributions than employers

Groups are thus better monitors of one another Groups effective systems of internal behavioral

governance Groups encourage cooperation Group synergies to work in teams more

responsive to incentives

Decision Information Costs

Agency Costs

Centralized

DecentralizedLocal information

Bird’s eye coordination

Where combined costs (Int CC) are minimized

Where to place decision rights?

Agency Monitoring costsCosts Bonding costs

Internal Residual lossCoordination

Costs Decision Information processing costsInformation Communication

Costs Documentation

Opportunity costs due to poor information

Hierarchical Coordination

Internal Coordination Costs

Search costs Transportation costs

Operational Inventory holding costs External Communication costs

CoordinationCosts Costs of writing contracts

Costs of enforcing contractsContractual

Market Coordination

External Coordination Costs?

Transaction Costs

Internal Coordination & Operations Costs

Optimal Firm Size

Total Cost

Optimal Firm Size

Specific and General Knowledge

“It is with respect to this that practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made only if the decisions depending on it are made with his active cooperation” (Hayek, 1945, p. 521-522)

There are two immediate options when attempting to co-locate knowledge and decision rights.

1. Moving the knowledge to those who make decisions2. Move the decision rights to those who have the

knowledgeConsequences1. A centralized system of control leads to high

information transferal costs and low agency costs2. A decentralized system leads to high agency costs

and lower information costs

The IS Problem

The IS Problem: Who cares???

Affects issues of: 1. Organization

2. Geographic location

3. Process definition and standardization

4. “Virtual” value chain coordination

Dependant upon:1. Uncertainty

2. Task definition

3. Interdependence

4. Risk

Old Economy or New Economy?

1. Data is visual, tactile and obtained directly from customers, suppliers and work

2. Workers tend to stay with firm because of pay schemes and benefits

3. Increasingly look outside of work for personal gratification and identity

4. Work is tightly integrated into family life and community

5. Emphasis on “tight control” of the production process through development of strict standards, policies and detailed procedures

Old Economy or New Economy?6. Increased isolation of workers from each

other and family and community7. Opportunities for career development are

limited except for as related to increased skill and expertise

8. Development of professional supervisor & middle manager roles; required to monitor work, control effort and output

9. Autonomous work teams are “empowered” to define work and manage production

Reengineering

Computers can gather most information more accurately and cost-effectively than people, they can produce summaries with electronic speeds, and they can transmit the information to decision-makers with the speed of light. Most interesting for our purposes is that, frequently, this information is so good and the analysis so precise that an executive decision is no longer required. . . . Anyone restructuring a company that does not take this new employee empowerment into account is not dealing with the future but is merely streamlining the past

Reengineering Principles Organize around outcomes, not tasks Have those that use the output of the process,

perform the process Subsume information-processing work into the

real work that produces the information Treat geographically dispersed resources as

though they were centralized Link parallel activities instead of integrating

their results Put the decision point where the work is

performed, and build control into the process Capture information once and at the source

Empowerment Define wide boundaries of procedural decision making Local sensitivity, responsiveness, Give employees authority to capitalize on here and

now..Problems Not always appropriate (risk, interdependence) Moral hazardSolutions Codify all alternatives in IT system, thus preempting

uncertainty (dangerous) Alternative, local governance mechanisms: e.g. teams

Across the hierarchy

ALKA Old sales process

contactcustomer

salesmeeting

sales leadlist

NO

Customer

Alka Regional office(Sales person)

Alka HQ

(Admin. processor)

sell policiy

registerinformation

Controlinformation

InformationOK?

YES

Specialistrequired?

specialist

YES

contactcustomer

contactsalesperson

confirminformation

confirminformation

NO

NO

NO

registercustomer

register/send policy

Policy

ALKA New sales process

contact customer

acceptcall

Customer

Alka HQ

register information

input cust. data in system

Specialist required?

specialist

send policy

Policy

NO

YES

Sales process reduced from 60 to 29 possible steps

ALKA Old claims adjustment

recordinformation

contactAlka

send claimsform

claims form written denial

controlinformation

requestadditional

information

coverage?

returnclaims form

input casedata in system

Info.OK?

exam byadjustor/specialist

payment

requestspecialist

requestadjustor

payment/close case

archive

evaluatecase

evaluatecase

NO

YES

NO

Customer

Alka Claims Admin.

Alka HQ

ALKA New claims adjustment

recordinformation

contactAlka

verbal denial(telehone)

coverage?input casedata in system

Info.OK?

exam byadjustor/specialist

payment

requestspecialist

requestadjustor

payment/close case

archive

evaluatecase

evaluatecase

YES

NO

Customer

Alka Claims Admin.

Alka HQ

Claims administration reduced from 139 to 44 possible stepsPaper based claims administration reduced from 97% to 4.8%Average accident claim processing time reduced from 32 to 6 days

Teams: Cooperation & Rivalry

Knowledge sharing & tournaments•Acquisition & coordination of knowledge•Reduction of asymmetric information•Increase learning

COOPERATION

COOPERATION

COOPERATIONCOOPERATION

COOPERATION

RIVALRY

Implicit Compensation

is often required when no explicit variables are readily available or easily measured. This is often the case with higher managerial positions, where the management of uncertainty is often required.

Empowerment can be seen as a move from an explicit to implicit incentive scheme.

Remember…Corporate Culture: Workable principles or routines of shared expectations that guide behavior in the face of uncertainty

Hawthorn Studies (Human Relations) organizations are social systems, not just technical economic systems we are motivated by many needs we are not always logical we are interdependent; our behavior is often shaped by the social context informal work group is a major factor in determining attitudes and

performance of individual workers management is only one factor affecting behavior; the informal group often

has a stronger impact job roles are more complex than job descriptions would suggest; people act

in many ways not covered by job descriptions there is no automatic correlation between individual and organizational

needs communication channels cover both logical/economic aspects of an

organization and feelings of people teamwork is essential for cooperation and sound technical decisions leadership should be modified to include concepts of human relations job satisfaction will lead to higher job productivity management requires effective social skills, not just technical skills