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Relationships between employees and employers involve inherent conflicts of interest. Firms naturally want workers dedicating their maximum efforts to priority projects in efficient ways. But employees may have different views of what is efficient, or have preferred approaches to their work that don’t match how employers want them to focus their efforts.

Contracts designed with incentives to minimize these conflicts can help, Becker Friedman Institute Visiting Scholar Erik Madsen explained at this talk for MBA students Oct. 24.

Economists have long been interested in when and how incentive pay can be used to improve employee performance. The traditional rationale for incentive plans is to promote effort when direct monitoring of employee activities is difficult or costly. Madsen focused how best to use incentive-based contracts in situations that arise out of asymmetric information, when the employee knows something about the job that the manager does not. It may benefit the firm to have the information, but revealing it is not advantageous for the employee.

For instance, employees may have the expertise to judge the viability of a project and inside information to know when it should end. But when they enjoy working on the project and don’t want to lose the resources and status it brings, they will be inclined to hide the true state and outcomes of the project from managers.

Preventing this sort of thing through closer supervision is time-intensive and costly. And performance pay doesn’t always solve the problem, due to natural variation in the skills and talents of people assigned to the project team. Madsen, an assistant professor at New York University, shared research that modeled how to write a contract that can improve on performance “without just accepting conflicts of interest as given,” he said.

He illustrated the approach with a hypothetical case study of a firm hiring a consultant to make proposals for improving practices and cutting costs. At the start of the engagement, both parties are uncertain about the scope of improvements to be gained and how long the project will run.

The consultant has the expertise to know when the project has hit its limits and will no longer yield enough savings to justify the cost, but is paid by the hour and has a financial incentive to extend the project. But after a sufficiently long dry spell without any improvements, the firm will end the engagement.

However, the consulting firm also cares about its reputation for producing results and wants to score return engagements with the firm, and will balance those factors when sharing information on the project status. This at-will employment arrangement is a tricky and delicate matter of trust, which can lead to firms terminating too early and missing big cost savings just over the horizon, or running up fees with no cost savings if the project drags on too long.

Madsen used option valuation techniques to compute the optimum length of such a project and potential savings in an at-will contract. Then he re-ran the calculations using three different incentive contracting tools.

First, he evaluated a contract that used completion bonuses.  In his hypothetical example, the firm promised the consultant a completion bonus of $5.9 million if the project is ever terminated. “That sounds huge, and it is,” he said. Calculated based on the fees in his original case, the fee was “exactly how much it takes for the consultant to not care anymore if the project ends. In other words, it could have lasted forever and the firm wouldn’t have done any better,” he explained. The consultant, getting paid no matter what, has no incentive to stretch out the engagement and will report truthfully when no more improvements can be found.

Completion bonuses alone (which Madsen termed “golden parachutes” or “pay for failure”) resulted in a -$2.2 million net present value for the firm, compared to $1.5 million for an at-will arrangement.

“There can be bad incentive contracting; you have to be careful how you do this,” he said. “So how do we limit it? We can add on deadlines to stem the losses of the completion bonuses.”

In this situation, the firm agrees to a project horizon, with a completion bonus proportional to remaining months in the contracted period if it decides to terminate early. This gives the consultant incentives to report truthfully, because its lost fees are small in the last months of the contract and offset by the bonus. On the other hand, if the relationship is running productively and the firm decides to extend beyond the deadline, the trust and incentive for information-sharing is lost.

This approach yields a net present value (NPV)  of $1.5 million for the firm—about the same as with no incentive contract. Adding on a third incentive tool called merit extensions turned out to be the trick that optimized value for all parties, Madsen showed.

Under this version, the firm commits to a project horizon of 20 months but resets the clock every time the consultant delivers a major improvement, and also uses a completion bonus. In this case, the consultant knows that if they don’t speak up when there are no more improvements, payment will end at the end of the period anyway. Thus not reporting the lapse in progress has the same effect as saying there are no more improvements to earn. And with the completion bonus, the consultants’ remaining earnings are independent of how long it waits to report the end of progress, which promotes information sharing.

An agreement with all three features turns out to be the optimal incentive contract, Madsen said. The NPV for the firm under this arrangement is $1.8 million—but all the time and work to develop the contract and set incentives correctly must be factored in on top of that, he cautioned.

“Incentive contracting can help; in instances where there are conflicts of interest, an incentive contract can resolve it, but you have to be careful about how you do it. If you do it poorly can be worse than not doing it at all,” he concluded.

Toni Shears

Managing through Incentives: The Economics of Dynamic Employment Relationships