Agency theory, the principal – agent model, and the economic theory of incentives are three names for the same thing: a collection of models created by economists to answer this question. We discuss the basic model in this subsection and elaborations following that.

The basic model begins with the supposition that the connection between time and effort exerted by the worker and the fruits of his labor services is not entirely under his control. The employee can influence the amount of work accomplished, by exerting himself, but he can\’t control output entirely. Supposing he is on the job for a set length of time, we let e denote the effort he chooses to exert over that period of time, and we suppose that the amount of work done x has a probability distribution that is affected by; think for now of the case where e is one-dimensional, and larger values of x are more likely the larger is.

In these circumstances, the employer probably wishes to pay on the basis of x – so much per post hole dug-whereas the employee prefers to be paid according to hours worked. The employer is unhappy paying by the hour, because then the employee has no incentive to exert himself; the employee is unhappy being paid per unit of x that is produced, because then he bears the risk of rocky soil, an ax breaking, and so on. (The conflict is more symmetrical if the amount of output is influenced both by the effort exerted by the employee and by some simultaneous and independent decision by the employer, such as the quality of shovels and pickaxes provided).

There are three implicit assumptions in what was just asserted, which are the foundations of the basic model of agency:

1 – The employee is averse to effort. That is, he will choose as Iowa level of e as he can and still get paid, if he is paid on a per-unit-of-time basis.

2 – The employee is averse to risk. If the employee were risk neutral – if he valued risky compensation according to its expected value-then he wouldn\’t object to being paid based on x, as long as his expected compensation was in line with market wages. The issue of incentive compensation is trivial in this case; compensation is set so the worker bears all the risk and thus completely and efficiently internalize the consequences of his choice of effort. Incentive compensation becomes more interesting when, based on first principles, the employee and employer should share the risk, rather than the employee bearing all the risk. Indeed, in the standard model it is assumed that the employer is risk neutral, so that on grounds of risk-sharing efficiency alone, the employer should bear all the risk as long as the employee is risk averse. And then the trade-off is: The more risk we load on the employee, the more he internalize the consequences of his choice of effort level, and the more efficient an arrangement we have in terms of motivation. But the more risk we load on him, the less efficient the arrangement is in terms of risk sharing.

3 – The parties cannot contract on the level of effort. If they could, and if the employer were risk neutral, then the efficient outcome would be to pay the employee a wage that depends only on leaving the employer to bear all the risk. Note that this is essentially the \”solution\” employed in practice in some cases, namely when the employer utilizes some technology to monitor the level of effort exerted by employees, with the threat of dismissal hanging over workers who are found to be exerting themselves insufficiently. But this solution is fraught with problems. Monitors are costly. It is potentially risky – for instance, what if the monitors conspire with the employees against the employer\’s interests? And in some cases, this solution is simply technologically impossible, or at least prohibitively expensive. So incentive compensation or pay for performance, where the agent\’s pay depends on the level of output x, may be the answer.

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http://www.arturvictoria.info/
http://sites.google.com/site/cliptheschoolbeginning/
http://sites.google.com/site/arturvictoriasite
http://adesg-europa.blogspot.com/

Author Bio: http://www.arturvictoria.info/
http://sites.google.com/site/cliptheschoolbeginning/
http://sites.google.com/site/arturvictoriasite
http://adesg-europa.blogspot.com/

Category: Business Management
Keywords: Organization, behavior, human, information, career, responsible, planning, human resources, leader,