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. Incentives play a crucial role in the field of economics. 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.

Principle/Agent Model

The principal-agent model is a framework used in economics to analyze the relationship between two parties: a principal and an agent. The principal hires the agent to perform a task on their behalf, but the agent may have different incentives and goals than the principal. The model is used to study how the principal can design incentives to align the agent's behavior with their own interests. This is important because the agent's actions can affect the principal's outcomes, but the principal may not have perfect information about the agent's actions or abilities. The model can be applied to a wide range of situations, such as employment contracts, corporate governance, and government regulation.

Design of Incentive Contracts

Types of Incetives

Fixed-wage contracts: Under a fixed-wage contract, the worker is paid a fixed wage, regardless of their performance. This type of contract does not provide any incentive for the worker to increase their effort level or improve their performance.

Piece-rate contracts: 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.

Tournament contracts: In a tournament contract, workers compete against each other for a prize or promotion. This provides a strong incentive for workers to improve their performance, but it may also lead to negative competition and the "tournament syndrome", where workers focus on winning the prize rather than on the overall objectives of the firm.

Optimal incentive contracts: An optimal incentive contract is designed to maximize the worker.

Performance Metrics

Objective performance measures: These are quantitative measures such as output, sales, or profits, which can be easily observed and verified. They are often used in piece-rate schemes, where the worker is paid a fixed amount per unit of output.

Subjective performance measures: These are more qualitative measures, such as the quality of work, customer satisfaction, or teamwork. They are often used in tournament schemes, where workers compete against each other for a prize or promotion, and in optimal incentive contracts, which combine objective and subjective measures.

Multiple performance measures: These include a combination of objective and subjective measures to provide a more comprehensive assessment of the worker's performance. The use of 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.

Relative performance measures: These compare the worker's performance to that of other workers in the same firm or industry. They are often used in tournament schemes and can provide a strong incentive for workers to improve their performance.

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.