ECON 426 Lecture Notes - Lecture 26: Risk Aversion, Marginal Cost, Marginal Utility
13 Jun 2018
School
Department
Course
Professor
Scalar effort
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Static salary related to productivity
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We analyzed a particularly simple problem of risk sharing and providing incentives
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Risk Sharing
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Incentives
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Important considerations:
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With both risk aversion on the part of agents and imperfect performance measures - first best effort
provision and perfect risk sharing couldn't be achieved
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Last Time
Broad or Narrow
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Quantitative or Qualitative
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Measurement - how to measure performance?
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If performance measure contains a lot of uncertainty it will result in a lot of risk if used for
incentivizing effort
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Requires thinking about agents who do more than just exercise "effort"
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Multi-tasking
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If the performance measure doesn't comprehensively capture a workers' output, it might
incentivize the wrong actions on the part of the agent
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What would make a bad performance measure?
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Today: Issues and Complications
Assume that the contribution of a worker to a firm is Q(e1, e2,...,ek)
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A broad measure would be an estimate of Q(e1, e2,...,ek) overall
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e.g. M(e1) - for example, the quantity produced, but not the quality
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Or hours, rather than output
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A narrow measure would be an estimate of only aspects of performance
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Broad or Narrow?
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Advantage of Quantitative measures are that they can be relatively easily tied to compensation using
mathematical and transparent formulae
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Quantitative measures often have a tendency to be narrow
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Qualitative vs. Quantitative
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Contain little risk that's outside the control of the agent
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Should reflect the employees' total impact on the firms' value
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A good performance measure should:
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The stock price contains a lot of stuff outside the control of the custodian
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If possible, measure the contribution of the custodian using something more closely tied to his
performance →focused performance measure
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Therefore, the stock price might be a decent performance measure for the CEO, but not the
custodian - why?
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A good performance measure for a CEO is not a good performance measure for a custodian
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Types of Performance Measures
A baseball player is based on the number of home runs hit?
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Loan officers is based on the number of loans originated?
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Programmers is based on the lines of code generated?
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Sales people is based on the sales in a given year?
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What problems will arise if compensation of:
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All these are examples of multitasking - the agent had several actions at her disposal, but by basing
compensation on a narrow, focused measure the actions of the agents are distorted
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Related problem: manipulation of quantitative measures
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The Problem with Focused Performance Measures
The Use of Subjective Performance
Lecture 26 - Much Ado About Incentives
Wednesday, April 18, 2018
11:20 PM
ECON 426 Page 1
Document Summary
We analyzed a particularly simple problem of risk sharing and providing incentives. With both risk aversion on the part of agents and imperfect performance measures - first best effort provision and perfect risk sharing couldn"t be achieved. If performance measure contains a lot of uncertainty it will result in a lot of risk if used for incentivizing effort. If the performance measure doesn"t comprehensively capture a workers" output, it might incentivize the wrong actions on the part of the agent. Requires thinking about agents who do more than just exercise effort Assume that the contribution of a worker to a firm is q(e1 , e2 ,,ek) A broad measure would be an estimate of q(e1 , e2 ,,ek) overall. A narrow measure would be an estimate of only aspects of performance e. g. m(e1 ) - for example, the quantity produced, but not the quality.
