15 Agency Costs:Incentives Matter

“If you would persuade, appeal to interest and

not to reason.”Benjamin Franklin

Poor Richard’s Almanack

1732-1758

Agency Costs

• Employees or contractors not behaving as they should — is a part of what we call Agency Costs or Agency Problems.

• Agency costs are a problem whenever a principal hires an agent to act on his behalf.

• Solving this universal problems is a key managerial problem in managing personnel and in controlling costs.

Why can’t people be this nice?

Drawback of Firms: Agency Costs

Agency costs arises from separation of ownership & control.

Owners of firms are interested in profit maximization.

Managers, employees, and suppliers are interested in maximizing their own self-interests.

How do we give employees incentives to act as if they were owners of the firm?

How do we get employees to not shirk—that is, work as hard as they can in the manner the owners would want? It is a matter of incentives.

Basic Human Nature

• This is what most people want to do when they are supposed

to be working:

• This is what we want

employees to be doing:

Agency Costs . . .

• These are a problem because we are human. If we “cheat” ourselves, then no one else bears the cost. So the one-person firm does not suffer agency costs.

• It is natural for us to want to exploit others: get others to pay more than they agreed to pay or we produce less than we agreed to produce. A divergence in interest between principal and agent in a multi-person organization and in contracts.

MonitoringWe have incentives to shirk – take more than we

should or work less than we should.

Monitoring is costly, so sensible to accept some losses.

Many forms of monitoring (spot checks, etc.).

Usually there is unequal (asymmetric) information between parties. One knows more than the other and can exploit that.

Examples:

Person selling used car (seller exploits buyer)

Buying insurance (buyer exploits seller)

Monitoring, Bonding & Signals

How do we assure customers that we can be trusted, so they should deal with us?

Various devices:

Fixed price contracts; Bonds; Warranties;

Take payment as % later (Accenture)

Less formal: Reputation. This matters greatly in the market. Diamond market in New York—close family, social and religious ties impose special discipline.

Managers and their Firms

• Key Managerial Problem:Giving employees incentives to act as if

they are owners.The entrepreneur or manager must cede

authority to others. The issue is: How do we structure an organization to reduce agency costs? The movement has been in this direction; especially in knowledge-based production.

Dealing with Agency Costs

Common solution: “Cost centers” within firms.

Hold each part of the organization accountable.

Problems: 1. How do you count overhead costs?

2. Accounting costs ignore some economic costs.

3. Parts of firm impose “tax” on other parts of firm, charging prices too high.

4.Organization become tied to internal suppliers (each part forced to buy from other inside parts—internal capital markets), internal suppliers protected from competition. Firm loses the benefit of market knowledge about costs and technology.

Decentralization: Pros & Cons

• Empowering workers and managers.

BENEFITS:

1. More effective use of local knowledge —

those closest know the most

2. Conservation of senior management —

top people cannot know or do everything

3. Training & motivation for local managers: helps attract and keep good managers and train future top managers

Decentralization . . .

Empowering workers and managers:COSTS:

1. Agency costs—shirking; self-dealing — so control and

monitoring measures needed2. Coordination costs and failures —

duplication; pricing errors3. Less effective use of central information—

local managers cannot know all information the central managers have, so have inferior knowledge

Team Production: Increasing or Decreasing Costs?

Create teams of people with expertises to make decisions—

Example—Hallmark Cards had teams of art, design, production and marketing assigned by holiday with decision rights rather than move produce from functional area to area—cut time in half.

Benefits—Improved use of specific knowledge and employee “buy in” due to better information, more cooperation & less blame.

Costs—Collective-action and free-rider problems.

Same thing in car production—team development tried at Chrysler; separate functional areas at GM. Tradeoffs.

Getting Workers to Monitor Each Other

• Nucor has been one of the few successful steel makers in the U.S. It keeps management small and adapts new technology quickly.

• Production workers are in teams. Base salaries are below industry standards. Teams are given production goals. Beating goals allows salary to be more than doubled. Penalties for mistakes are severe, so quality maintained. If one worker shirks then everyone suffers.

• Who is likely to want to work at Nucor?• And: Greater ability to protect workers in recession.

Simple Rules May Not Work So Well

3M is an innovative company with 50,000 products, but most income is from a few products.

Company had a rule that 30% of each division’s sales must be from new products every 4 years. Forced innovation. Company was performing below average.

New CEO studied the innovations. Many were trivial—change the color of a product and call it new.

Scrapped the 30% rule; focus on best products and on small number of innovations that look promising.

Some Traditional Systems (Piece Rate) Can Work Well

Safelite Glass is largest installer of windshields on cars in U.S. (windshield replacement).

Workers were paid hourly wage rate—drive to customer location and install windshield. Average was 2.7 windshields per day.

Company changed to piece-rate compensation—low base salary plus bonus for each windshield installed. Productivity increased 20% (3.24 windshield per day per worker). Workers were happier & less turnover of good workers.

It Happens High Level and Low

In 2005, the Merrill Lynch board approved new incentive program for CEO and senior managers: raise return on equity in the next 3 years and you get rich. Given that incentive, what happened?

1. Merrill repurchased $9 billion of its existing stock to increase return to remaining stock.

2. Firm went more heavily in high-risk assets such as sub-prime mortgages (high risk = high return).

Result: 2006 great! Short term thinking, not long.

What happened in the crash in 2008?

Other incentives…

• Not everyone can have stock options. Cash bonuses work well at lower levels—a goal to strive for—getting a nice big payoff.

• BUT—people respond to incentives so watch how rewards structured.

• Why the sub-prime mortgage mess? Banks paid lenders based on quantity of mortgages made, not quality. If pay for quantity, better have a quality measure in place too—charge back for failures (rather like car dealership repairmen).

Are Incentives Right?

Dealers at casinos in Las Vegas earn about $100,000 per year—almost all on tips. Their wages are about $12,000.

Casino owner Steve Wynn ordered tip money pooled and shared with managers.

Why?

Question on Team Incentives

• Suppose different numbers of people are assigned to pull a rope “as hard as you can.”

• One person pulls the rope.• Three people pull the rope together.• Eight people pull the rope together.• How does the pulling force (work effort) per

person change across these three cases?

Incentives of Managers

In the fast-food industry, 30% of stores are company owned and run by a salaried manager. 70% of the stores are run as franchises by owner-operators who split profits with the parent company. 1) Which kind of store would you think would tend to be more profitable? 2) Why then does the parent choose to own some? Where would they be located?3) Would you expect employees to see a difference in the managers?

Corporations Have Problems

In sum, the corporate form of organization is not perfect.

The alternatives—non-profits and government bureaus—have far worse performance problems.

Much of modern wealth is tied to the rise of the modern business organizations—getting incentives right.