Deck 15: Incentive Compensation

Question 1

The basic incentive problem is that owners and:

A) employees have similar objectives.
B) employees have fundamentally different objectives.
C) employees need government assistance to solve differences.
D) banks provide funding for growth.

Answer 1

B

Question 2

Some industrial psychologists suggest that, "pay is not a motivator". How do they support the argument and what are the limitations of that argument?

Answer 2

As support for this view, it is pointed out that workers rank the work environment higher than salary. Second, it is difficult to design an efficient incentive compensation plan, since many plans have backfired and produced exactly the wrong kind of results. The problem with this line of reasoning is if money is not a motivator, then it should not produce any results, good or bad. Since bad results are produced when money is a motivator, we have a situation where some clauses can be incorporated into the contract, which have the potential for improving and mitigating the circumstances. Further, these contract designs have been in place for a long time and scientific evidence suggests that they work well when designed properly.

Question 3

Why do many firms base incentive pay on group performance?

Answer 3

There are several advantages for setting up group incentive plans. Group performance is easier and cheaper to measure than individual performance. Group pay encourages team work and mutual cooperation based on team members self selecting into tasks based on their skills. Group work also limits free-riding since each person can monitor others. Group work also retains employees, and gives them confidence about tenure. Group performance also reduces contracting costs since groups' compensation can be adjusted based on opportunity costs.

Question 4

The DuPont case is a good example of an incentive package gone awry. In review, it placed a portion of employee's pay into an "at-risk pool." If the division had exceeded expectations, the employees would have received a bonus from the pool. How would a "relative performance contract" have saved the DuPont bonus system?

Question 5

FancyFoods provides a monthly bonus for servers when sales volume exceeds 120 percent of the same month last year. The size of bonus is tied to the individual server's sales of meals relative to the average server's sales. This system attempts to introduce a(n):

A) risk-sharing contract.
B) relative performance contract.
C) absolute performance contract.
D) group performance contract.

Question 6

When employees are offered incentives to find new customers, but the aggregate economy is so weak (in recession) that the firm loses consumers, then the incentive plan:

A) is just what was needed in hard times.
B) must be adjusted to make employees work harder in difficult times.
C) suffers from the problems of external risks that employees cannot overcome.
D) must be adhered to no matter what.

Question 7

Economists believe the free rider problem is very important in complex business organizational structures. Still, businesses continue to build teams to solve problems or to deliver products to consumers. Often special rewards or bonuses are provided to the team rather than to the individuals on the team. Write a brief essay that either defends the economists' concern or explain why economists are wrong on this issue.

Question 8

If all issues of effort, output, and pay are fully observable and contactable between an owner and an employee, then:

A) incentive conflicts can be eliminated.
B) incentive conflicts remain intractable.
C) the utility of the employee is unimportant to the outcome.
D) revenues of the firm are independent of employee effort.

Question 9

A compensation program that includes all performance indicators that influence an employee's output is called the:

A) informativeness principle.
B) incentive coefficient.
C) risk-sharing premium.
D) efficient bargaining solution.

Question 10

The rate at which an employer provides an incentive for an employee to perform (to increase effort) is the:

A) informativeness principle.
B) incentive coefficient.
C) risk sharing premium.
D) efficient bargaining solution.

Question 11

An efficient allocation of risk among employees and owners must:

A) take into account that performance-based incentives are the sole important component of an employee's salary.
B) take into account that attitudes toward risk differ among different people.
C) recognize that inefficiency is inherent to the process.
D) recognize that pooling of risks is never appropriate.

Question 12

Give a few examples of incentive compensation.

Question 13

Consider the salary of Mary Sue Nelson, a sales agent for Plain Truth Advertising. She has an effort cost of C = e² and she a reservation wage of $1,500 so that wage package is W = 1,500 + .2 Q where the CEO sets the incentive at .2 and Q = 200 e. If the CEO increases the incentive from .2 to .25, what happens to the Nelson's effort? Will profits rise or fall?

Question 14

Compared to owners, employees receive a large fraction of their incomes from their employers and are consequently very dependent on the fortunes of that company in the marketplace. From a 'risk-sharing' perspective, an employee tends to prefer:

A) a flat salary.
B) output-based incentive pay.
C) year-end based performance pay.
D) incentive based pay

Question 15

Use the following example to review the basic incentive problem in the owner/employee conflict. Assume perfect contracting possibilities. Chef Tom Malone is the key employee for FancyFoods. His utility is defined by
U = I - e² and his reservation wage is $2,000 per week.
FancyFoods costs = Malone's wages = $2,000 + e²
FancyFoods benefits = revenue = 300e
Profits = Revenues - Costs
Compute the optimal wage bill for Chef Malone, the revenues for FancyFoods, and the profits earned by FancyFoods.

Question 16

Dan Heath is the majority owner of Plain Truth Advertising. He hires Shirley Downs as his chief executive officer (CEO). In terms of an economic model, Mr. Heath is the __________ and Ms. Downs is the _________.

A) agent; principal.
B) principal; agent.
C) principal; intermediary.
D) agent; intermediary.

Question 17

Dan Heath is the owner of Plain Truth Advertising. He is attempting to design salary systems for his employees, most of whom are sales agents. To get a good system, he needs to recognize the trade-offs between:

A) benefits and incentives.
B) risk sharing and benefits.
C) benefits and salaries.
D) risk sharing and incentives.

Question 18

Consider the salary of Mary Sue Nelson, a sales agent for Plain Truth Advertising. She has an effort cost of C = e² and she a reservation wage of $1,500 so that wage package is W = 1,500 + .2 Q where the CEO sets the incentive at .2 and Q = 200 e. Here effort is known only by the employee. There is a random shock to output each period whose mean is zero.
(a) What is the optimal effort for Mary Sue Nelson?
(b) On average, what total wage or salary will she earn each month?
(c) On average, what is the output of sales contracts that she makes?
(d) On average, what kind of profit will the CEO earn off of Nelson's work?

Question 19

What are the factors that favor high incentive pay for an employee? Explain which of the five factors is the most important.

Question 20

What is the role of the "informativeness principle" in designing a compensation package for an individual in a corporate environment?

Question 21

One possible solution to an incentive problem arising under unobservable actions is:

A) pay more and make the worker efficient.
B) be the boss and fire the inefficient worker and send a signal to others.
C) buy the agent's right to his total output.
D) sell the agent the right to the total production.

Question 22

To qualify as incentive pay, a performance-based compensation program:

A) must use monetary rewards.
B) must use only non-monetary rewards.
C) may use either monetary or non-monetary rewards.
D) may only use piece rates and commissions.

Question 23

Strong incentives are provided by:

A) fixed salaries.
B) pay on performance.
C) fixed salaries and limited pay on performance.
D) threatening to outsource the job to Bangalore.

Question 24

Alfie Kohn and Demming are of the opinion that:

A) pay is a prime motivator.
B) work place and environment are not important motivators.
C) pay is not a motivator.
D) incentive plans all work too well.

Question 25

The informativeness principle tells us that:

A) information is overrated because employees can always lie about their performance, and detecting is costly and counter productive.
B) you must use as much information as possible to develop compensation contracts, evenif the cost of obtaining the information is unreasonable.
C) you must use just sufficient information as possible to develop compensation contracts, as long as the cost of obtaining the information is reasonable.
D) you must use as much information as possible to develop compensation contracts, as long as the cost of obtaining the information is reasonable.

Question 26

It is better to pool risks because :

A) you can increase your income.
B) you can reduce your expected income but increase its standard deviation.
C) you can reduce the variability of expected income.
D) you can increase your expected income.

Question 27

Consider the salary of Mary Sue Nelson, a sales agent for Plain Truth Advertising. Her weekly wage package is W = 1,000 + .4Q, where Q is her dollar volume of sales. Her productivity is Q = 200e + , where e denotes her hours of effort and , is a random variable with mean 0. If Mary Sue works an additional hour, the expected value of her wages rises by:

A) $0.00.
B) $80.00.
C) $200.00.
D) $1,000.00.

Question 28

Since the1980s, the compensation of CEOs in large corporations has been increasingly tied to performance of the common stock of the company. Research now indicates that if the value of the firm changes by $1,000, the wealth of CEO changes by:

A) $1,057.00.
B) $105.70.
C) $10.57.
D) $1.57.

Question 29

Three difficulties that limit the usefulness of ownership in resolving incentive problems are:

A) wealth constraint, free riding and bundling.
B) risk aversion, free-riding and conflict of interests.
C) wealth constraints, risk aversion and bundling.
D) wealth constraints, risk aversion and free-riding.

Question 30

Incentives would not be a problem if:

A) not all actions were observable.
B) some actions were observable.
C) actions were not observable.
D) actions were observable.

Question 31

Consider the salary of Mary Sue Nelson, a sales agent for Plain Truth Advertising. Her wage package is W = 1,000 + .4Q, where Q is her dollar volume of sales. Her productivity is Q = 200e + , where e denotes her hours of effort and m is a random variable with mean 0. She has an effort cost of C = e² . Under this contract, the expected value of her total wages will be:

A) $200.00.
B) $1,000.00.
C) $3,060.00.
D) $4,200.00.

Question 32

There is scientific evidence to suggest that:

A) agents respond to incentives.
B) agents do not respond to incentives.
C) agents respond to piece rates but not bonus plans.
D) agents respond to incentives only if they can cheat.

Question 33

FancyFoods belongs to the Restaurant Trade Association. One of the services that the trade association provides is monthly data on total regional sales of restaurants. In designing a bonus system for employees, this service:

A) would not be useful because it too expensive.
B) would not provide useful information for performance-based contracts.
C) may provide low-cost information for performance contracts.
D) may deceive the owners from knowing what is actually happening in the region.

Question 34

Consider the salary of Mary Sue Nelson, a sales agent for Plain Truth Advertising. Her wage package is W = 1,000 + .4Q, where Q is her dollar volume of sales. Her productivity is Q = 200e + , where e denotes her hours of effort and m is a random variable with mean 0. She has an effort cost of C = e². Under this contract, her choice of effort will be:

A) 0 hours per week.
B) 20 hours per week.
C) 40 hours per week.
D) 80 hours per week.

Question 35

Team production is a limiting factor as a solution to incentive problems since:

A) entire teams may be inefficient.
B) some team members may choose to shirk and let the rest carry the load.
C) some team members never get along and start back biting.
D) some team members may perceive the team leader to be a moron.

Question 36

The text quotes W. Edwards Deming as saying that "pay is not a motivator." The history of incentive pay plans shows that:

A) they rarely work.
B) incentives work in every instance.
C) there is mixed record in success of incentive pay plans.
D) incentives must be non-monetary to work.

Question 37

Incentives would not be a problem:

A) as long as employers get what they want.
B) if the interests of the employees and the employers conflict somewhat.
C) if the interests of the employees and the employers conflict.
D) if the interests of the employees and the employers were perfectly aligned.

Question 38

Terence Riggan has four tasks assigned to him on the job: stocking, sales, restocking, and display building. The company wants Terence to spend 50 percent of time on sales, but needs the other tasks done daily. Building an incentive program to get this done is:

A) difficult.
B) based on the informativeness principle.
C) a necessary evil.
D) totally dependent on a relative performance contract.