Average Process
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What is an Agency Problem and what causes it?
An Agency Problem arises when the objectives of an Agent and the Principal differ and the actions of an Agent cannot easily be observed by the Principal. The Agent will work towards his own goal which might hurt the Principal.
(see book page 402)
How do Performance-based Incentives eliminate Agency Problems?
They align the objectives if the Agent with the ones of the Principal. Therefore the Principal does not need to monitor the Agent anymore since he knows that a rational Agent will follow his own objectives.
(see book page 404)
What are problems of Performance-based Incentives?
If an Agent´s payoff is tied to a factor he cannot completely control, the company has to reward him extra for taking the risk of a variable pay.
The second problem is that not only the factor that determines the payoff of an Agent is important for firm. The Agent, however, focuses mainly one the part of the job he is being paid for.
(see slides Lecture 5)
What are the possibilities to eliminate an Agency Problem?
Monitoring, Bureaucracy and Performance-based Incentives
(see slides Lecture 5)
What are the criteria for a good performance measure?
Firstly, a good performance measure should be as controllable as possible by the Agent. This way the necessary risk premium of the variable pay is smaller. Secondly, it should reflect all activities that a firm wants to be undertaken by the employee. Finally, it should not be possible for the employee to improve the measure by conducting activities that hurt the firm.
(see book page 417-418)
What is the problem of performance-based incentives in teams and how can it be solved?
Since the whole team is rewarded for its achievements but not the individual employees team compensation can lead to free-riding of employees. This can discourage the other members of the team to work hard. Free-riding can be reduced when teams are smaller and they work together more than once since punishing free-riders becomes easier and therefore the incentive to free-ride is reduced.