Incentive contract

Authored Mateusz Szaryk

Abstract

Incentive contracts are agreements between two parties in which one party provides incentives for the other to undertake a certain action. These contracts are used in various settings, including employment, procurement, and government regulation, and are motivated by the desire to align the interests of the contracting parties and encourage the party receiving the incentives to behave in a manner that benefits both parties. The use of incentives in contracts has been shown to lead to improved performance and increased efficiency. For example, firms that use incentive-based compensation for their employees have higher productivity and better financial results than those that do not. In procurement, the use of incentives in contracts leads to improved product quality and reduced costs.

However, designing incentive contracts can be challenging. If the incentives are not well-designed, they can have unintended consequences and actually lead to suboptimal outcomes. The design of incentive contracts requires careful consideration of the incentives offered, the performance metrics used to evaluate the party receiving the incentives, and the potential for moral hazard. Incentive contracts can also pose challenges in implementation, such as measuring performance and mitigating moral hazard.

Despite these challenges, incentive contracts have become an increasingly popular tool for improving performance and encouraging cooperation in a variety of settings. For example, in the employment setting, incentive-based compensation has become more common, as firms seek to align the interests of their employees with those of the firm. In procurement, incentive contracts have been used to encourage suppliers to improve product quality and reduce costs. In government regulation, incentive contracts have been used to encourage firms to adopt environmentally friendly practices.

Application

Incentive contracts take greatly from the world of economics and human behaviour and are therefore best understood through the lense of incentive theory and applied through the principle/agent model which will be further explored in this section. These two concepts are fundamental towards designing of incentive contracts. At the heart of the matter, demand revolves around identifying ways to encourage consumers to acquire greater quantities of a particular item, essentially offering incentives to stimulate purchases. In the same vein, supply relationships depict how economic agents increase output or labor in reaction to enhanced remuneration. The central idea is that this model can be applied across a broad range of areas and have a presence in project, programme and portfolio managment through the virtue of being a binding framework agreements towards achieveing output. This could be in case of hiring external consultants and proffesional to contribute towards a project, contracting vendors for long term collaboration or alligning organisational structures towards programme goals and policy deployment. Incentive contracts are very granular, depending on what is to be achieved there can be a large variety of apporaches towards leveraging incentives can be taken and they therefore application becomes very unique. This article will outline general principles and types of incentives to be taken into account when going into designing an incentive contract

Incentive Theory

Incentive theory has its origin in the desire to understand human behavior and motivation. Adam Smith, in his book "The Theory of Moral Sentiments" argued that humans have an innate desire to please others and avoid offending them. This desire for social approval and disapproval is the basis of incentive theory. Incentive theory assumes that people are motivated by rewards and punishments, and that these incentives can be used to influence behavior. It is based on the idea that people are motivated by the desire to maximize their own self-interest, and that they will act in ways that they believe will lead to the greatest rewards or benefits. However, recent research has shown that people are also motivated by social factors, such as the desire for social esteem and the need to maintain positive relationships with others. Incentive theory is often used in the field of organizational behavior to understand how managers can motivate employees to achieve organizational goals.

Principle/Agent Model

The principal/agent model is a framework used in incentive theory to analyze the relationship between a principal (such as a manager or employer) and an agent (such as an employee or contractor). The model assumes that the agent has superior information about their own abilities and effort, while the principal has limited information and must rely on observable outcomes (such as performance or profit) to design incentive schemes that motivate the agent to act in the principal's best interest.

This model can be applied in various scenarios, such as employment contracts, corporate governance, and regulatory policy. For example, an employer may use incentive schemes (such as bonuses or promotions) to motivate employees to work harder and increase productivity. A board of directors may use incentive schemes (such as stock options or performance-based pay) to align the interests of executives with those of shareholders. A regulator may use incentive schemes (such as fines or subsidies) to encourage firms to comply with environmental or safety standards. The principal/agent model provides a framework for analyzing the effectiveness of these incentive schemes and identifying potential problems, such as moral hazard or adverse selection.

Design of Incentive Contracts

Allignment of Incentives

Alignment of incentives is a fundamental aspect of incentive contracts, as it ensures that the interests of both parties, such as employers and employees, converge towards common objectives. When incentives are properly aligned, they encourage individuals to act in ways that promote the overall goals of an organization or partnership, which can lead to increased efficiency, productivity, and collaboration. Achieving this alignment can be challenging due to factors such as information asymmetry, differing preferences, and varying risk tolerances among the involved parties. To overcome these challenges, incentive contracts can include a mix of objective and subjective performance measures, risk-sharing mechanisms, and monitoring systems to ensure that the incentives provided are driving the desired behaviors and outcomes.

Types of Incetives

Fixed-wage: Fixed-wage contracts represent a common form of employment agreement, wherein the employee is paid a fixed wage or salary regardless of their performance or output levels . This type of contract offers several advantages and disadvantages, depending on the context and the nature of the work being performed.

One primary advantage of fixed-wage contracts is their simplicity . The employee knows exactly what they will be paid, and the employer knows the exact cost of labor. This arrangement can provide a sense of stability and predictability for both parties, which can be especially beneficial in industries or jobs with highly variable output levels or seasonal fluctuations.

Fixed-wage contracts can also help minimize the risk for employees who may be risk-averse . Since the employee's compensation is not tied directly to their performance or output, they do not have to worry about fluctuations in income based on factors beyond their control, such as market conditions or company performance.

However, fixed-wage contracts can also present certain challenges, particularly in the context of aligning incentives between the employee and the employer. Since the employee's compensation is not directly tied to their performance, there may be less incentive for them to put forth maximum effort or strive for exceptional results (Lazear, 1998). This can potentially lead to issues of moral hazard or shirking, where employees may not be as motivated to work hard or may engage in behaviors that are not in the best interest of the employer .

To mitigate these issues, employers may need to implement additional performance management practices, such as performance appraisals, regular feedback, and goal-setting, These practices can help align the employee's incentives with those of the employer and encourage better performance. However, it's important to note that the effectiveness of these practices can depend on various factors, such as the quality of communication between the employee and the employer, the clarity of performance expectations, and the employee's intrinsic motivation.

In summary, fixed-wage contracts offer simplicity and predictability for both employees and employers, but they may not always provide the most effective means of aligning incentives and promoting optimal performance. Employers should carefully consider the specific context of their industry and the nature of the work being performed when deciding whether a fixed-wage contract is the best choice for their organization.

Piece-rate:Under a piece-rate contract, the worker is paid a fixed amount per unit of output. This provides an incentive for the worker to increase their output and work harder, but it may not address issues of quality or teamwork.

A significant advantage of using piece-rates as an incentive contract is that it accommodates heterogeneity in worker abilities. More able workers, who have lower effort costs, choose higher effort levels and are paid more, leading to no inefficiencies from having workers of different abilities in the firm. If capital is significant, only workers above a certain ability threshold will choose to work, but workers self-sort, eliminating the need for the firm to intervene.

Linear piece-rates may no longer be appropriate incentive contracts if workers are risk-averse. In general, a nonlinear scheme will perform better but will fail to achieve first-best solutions. As long as asymmetric information exists, so that individual actions cannot be observed and contracted upon, Pareto-optimal risk-sharing is not possible.

Tournament: The individual with the highest output receives the winning prize, such as a high-wage job, while the other obtains the losing prize, like a low-wage job. By increasing the difference between the winning and losing prizes, workers are motivated to work harder. The optimal difference pushes workers to a point where the marginal cost of effort equals the marginal (social) return on that effort.

There are two primary advantages to payment through a tournament method. Firstly, tournaments only require making relative comparisons between workers, which may be more cost-effective than determining each worker's exact output. Secondly, compensation by rank eliminates the impact of common noise. For instance, low sales might be due to an economic slump rather than workers' efforts. Since the slump affects both workers equally, relative comparisons remain unaffected. The best worker still produces more, even if both produce small amounts.

Tournament-type incentive contracts encourage workers to behave efficiently if they are risk-neutral. These contracts are easy to use but have a significant drawback: workers increase their probability of winning not just by performing well themselves but also by causing their opponent to perform poorly. This dynamic discourages cooperation and results in wage compression, which in turn discourages aggressive behavior among workers competing for the same job.

Performance Metrics

Objective performance measures , as stated, are quantitative measures such as output, sales, or profits that can be easily observed and verified These measures are commonly used in piece-rate schemes, where the worker is paid a fixed amount per unit of output . Holmstrom (1979) argues that the use of objective performance measures can help to mitigate moral hazard issues since the worker's compensation is directly tied to their performance.

Subjective performance measures , on the other hand, are more qualitative measures, such as the quality of work, customer satisfaction, or teamwork . These measures are often used in tournament schemes, where workers compete against each other for a prize or promotion (Lazear & Rosen, 1981), and in optimal incentive contracts, which combine objective and subjective measures . Holmstrom highlights that the use of subjective performance measures can be particularly beneficial when objective measures are not available or do not fully capture the worker's contribution to the firm

Multiple performance measures involve a combination of objective and subjective measures to provide a more comprehensive assessment of the worker's performance . Using multiple measures can reduce the risk of "gaming" or strategic behavior by the worker, and can also help to address the issue of incomplete contracts . Using multiple performance measures can lead to more efficient outcomes, as it allows for better alignment of incentives between the worker and the firm.

Relative performance measures compare the worker's performance to that of other workers in the same firm or industry . These measures are often used in tournament schemes and can provide a strong incentive for workers to improve their performance. Relative performance measures can be especially useful when absolute performance measures are noisy or subject to external influences, as they allow the firm to filter out common shocks affecting all workers.

Limitations of Incetive Contracts

Incomplete contracts: Incentive contracts may not fully capture all the relevant aspects of the employment relationship, such as the worker's effort level or their contribution to teamwork. This can create problems of moral hazard, where the worker has an incentive to shirk or engage in other behavior that is not in the principal's interest.

Strategic behavior: Incentive contracts may create incentives for workers to engage in strategic behavior, such as gaming or manipulating the performance measures, to maximize their compensation. This can undermine the effectiveness of the incentive contract and lead to unintended consequences.

Risk aversion: Workers may be risk-averse and may not want to accept an incentive contract that is too risky. This can create problems of adverse selection, where only the most risk-tolerant workers accept the incentive contract, leading to a negative selection bias.

Measurement problems: Incentive contracts rely on performance measures to assess the worker's performance and determine their compensation. However, the choice of performance measures may not fully capture the worker's contribution to the firm or may be subject to measurement error.

Costs of monitoring: Incentive contracts may require additional monitoring and supervision to ensure that the worker is meeting the performance targets. This can be costly for the principal and may lead to a reduction in the worker's autonomy and job satisfaction.

Moral Hazards

The moral hazard model is a type of principal-agent model used in economics to study situations where a principal (such as an employer) hires an agent (such as an employee) to perform a task, but the agent's effort or actions are unobservable to the principal. As a result, the agent may have an incentive to shirk or take excessive risks, knowing that the principal cannot observe or fully control their behavior.

In the context of the moral hazard model, "moral hazard" refers to the idea that the agent may change their behavior in ways that are costly or harmful to the principal, once they have been hired and have some degree of autonomy. For example, an employee might take longer breaks or put less effort into their work if they know that their supervisor cannot monitor them closely.

To address the problem of moral hazard, the principal may design a contract that provides incentives for the agent to take actions that align with the principal's interests. For example, the contract might include performance-based pay or bonuses that reward the agent for achieving specific goals or outcomes. The principal might also use monitoring or other forms of supervision to reduce the agent's ability to shirk or take excessive risks.

However, the design of optimal contracts for addressing moral hazard can be complex and depends on many factors, such as the agent's preferences and risk attitudes, the degree of information asymmetry between the principal and agent, and the costs and benefits of various monitoring and incentive mechanisms. The moral hazard model is a useful tool for analyzing these factors and developing effective strategies for addressing the problem of moral hazard in different organizational contexts.

Unintended Consequences

Gaming: Incentive contracts may create incentives for workers to engage in gaming or strategic behavior to manipulate the performance measures and maximize their compensation. This can undermine the effectiveness of the incentive contract and lead to unintended consequences.

Cream-skimming: Incentive contracts may create incentives for workers to focus on high-margin or easy-to-achieve tasks, rather than on tasks that are more difficult or require a higher level of skill. This can lead to a bias in the selection of tasks and may not reflect the worker's true abilities.

Negative externalities: Incentive contracts may create negative externalities, where the worker's actions have a negative impact on other workers or the firm as a whole. For example, a worker who is rewarded for increasing their output may create bottlenecks or quality problems in the production process, affecting the overall performance of the firm.

Tunnel vision: Incentive contracts may create tunnel vision, where the worker focuses on the performance measures that are being rewarded, rather than on the overall objectives of the firm. This can lead to a narrow focus on short-term results and may not reflect the worker's contribution to the long-term success of the firm.

Annotated bibliography

Kerzner, H. (2017). Project Management: A Systems Approach to Planning, Scheduling, and Controlling. John Wiley & Sons. - This comprehensive project management book provides a detailed overview of various project management methodologies, including incentive contracts and their application in managing projects.

Bubshait, A.A., & Almohawis, S.A. (1994). Evaluating the general conditions of a construction contract. International Journal of Project Management, 12(3), 133-135. - This journal article discusses the importance of contract management in the construction industry and highlights incentive contracts as a potential strategy for improving project outcomes.

Pinto, J.K., & Slevin, D.P. (1988). Project success: definitions and measurement techniques. Project Management Journal, 19(1), 67-72. - This seminal paper defines project success and offers a comprehensive approach to measuring project performance, which can be applied when designing incentive contracts.

Merna, T., & Al-Thani, F.F. (2008). Corporate Risk Management. John Wiley & Sons. - This book offers an in-depth look at corporate risk management, including the role of incentive contracts in aligning stakeholder interests and managing.