Principal agent problems and incentive pay schemes

5 July, 2017 at 15:47 | Posted in Economics | Comments Off on Principal agent problems and incentive pay schemes

If bonus or “incentive pay” schemes work so well for senior executives and bankers, why does everyone not get them?

The conventional answer is that a bonus scheme or incentive plan will indeed encourage the recipients to make more money for the shareholders or clients on whose behalf they act …

juggleA classic paper on the “principal-agent problem” … by Bengt Holmstrom and Paul Milgrom pointed out that the conventional answer makes the mistake of assuming that jobs are simple and consist only of one task. In reality, agents — such as executives acting on behalf of shareholders — have multiple tasks with many dimensions. Some of these will be easier to measure than others …

The more complex the job, the more dimensions involved — as in being a corporate chief executive, say — the less justification there is for an incentive reward scheme. This is reinforced in the specific context of shareholder principals and chief executives, when the latter are responsible for the value of the assets they are managing on behalf of the company’s owners. Incentives linked to whatever can easily be measured lead agents to turn their efforts away from maintaining and enhancing the value of the asset over time …

As the economy becomes increasingly complex and intangible, monitoring and measuring seem ever harder. The simplistic case for bonus and incentive pay schemes grows ever weaker.

Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers doing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.

Diane Coyle

At a deeper level this ‘puzzle’ confirms that the alleged close connection between productivity and remuneration postulated in mainstream income distribution theory simply does not exist.

The idea that capitalism is an expression of impartial market forces of supply and demand, bears but little resemblance to actual reality. Especially when it comes to  people that basically set their own salaries, you find a rather strong inclination for generous self-rewarding.

economic-mythWealth and income distribution, both individual and functional, in a market society is to an overwhelmingly high degree influenced by bargaining power, institutionalized political and economic norms, things that have relatively little to do with marginal productivity in complete and profit-maximizing competitive market models – not to mention how extremely difficult, if not outright impossible it is to empirically disentangle and measure different individuals’ contributions in the typical team work production that characterize modern societies; or, especially when it comes to ‘capital,’ what it is supposed to mean and how to measure it. Remunerations, a fortiori, do not necessarily correspond to any marginal product of different factors of production – or to ‘compensating differentials’ due to non-monetary characteristics of different jobs, natural ability, effort or chance.


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