Deck 15: Incentive Compensation

Question 1

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 1

To support 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 2

Consider the salary of Mary Sue Nelson,a sales agent for Plain Truth Advertising.She has an effort cost of C = e² and a reservation wage of $1,500 so that wage package is W = 1,500 + 0.2 Q where the CEO sets the incentive at 0.2 and Q = 200 e.If the CEO increases the incentive from 0.2 to 0.25,what happens to Nelson's effort? Will profits rise or fall?

Answer 2

Under the 0.2 incentive,Mary Sue's expected benefits are 1,500 + 0.2Q = 1,500 + 0.2(200e)= 1,500 + 40e.Her marginal expected benefit from another hour of effort is therefore 40.Her marginal cost from effort is 2e.Therefore her optimal effort is 40 = 2e or effort is 20 hours.,She will earn E(W)= 1500 + 0.2(200(20))= $2,300.Her output is E(Q)= 200(20)= $4,000 in sales revenue.Expected profit for the company is E(Q - W)= 4,000 - 2,300 = $1,700.Solving the problem under the higher incentive of 0.25,her marginal expected benefit is 0.25(200)= 50 and her optimal effort satisfies 50 = 2e or e = 25.Therefore,her effort increases.Expected output increases to Q = 200(25)= $5,000.Expected wages are 1,500 + 0.25(200(25))= $2,750.Expected profit will rise,in this case,to $2,250.

Question 3

Incentives are not likely to pose a problem:

A)as long as employers can exploit the employees.
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 are perfectly aligned.

Answer 3

D

Question 4

It is better to pool risks because you can:

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

Question 5

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

A)wealth constraints,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 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)suffers from the problem of diminishing reservation utility.
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

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 8

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 in the team.Write a brief essay that either defends the economists' concern or explains why economists are wrong on this issue.

Question 9

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

Question 10

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 11

The basic incentive problem is that owners and employees:

A)are both concerned about sales maximization.
B)have fundamentally different objectives.
C)need government assistance to solve differences.
D)generally operate in perfectly competitive markets.

Question 12

Consider the salary of Mary Sue Nelson,a sales agent for Plain Truth Advertising.She has an effort cost of C = e² and a reservation wage of $1,500 so that her compensation package is W = 1,500 + 0.2 Q,where the CEO sets the incentive at 0.2 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 13

Compared to owners,employees receive a large fraction of their incomes from their employers and are consequently 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)commission-based incentive pay.

Question 14

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

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

Question 15

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 employees have full control over their output.
D)recognize that pooling of risks is never appropriate.

Question 16

Incentives are not likely to be a problem if:

A)workers' efforts are not contractible.
B)only some actions are observable.
C)all actions are observable.
D)actions are not observable.

Question 17

Which of these situations limit the use of ownership in resolving incentive problems?

A)The employees are well trained and highly qualified.
B)The employees try to maximize their personal utility.
C)The employees lack full control over their output.
D)The actions of employees are unobservable.

Question 18

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 19

Why do many firms base incentive pay on group performance?

Question 20

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

Question 21

By offering a compensation package rich in fringe benefits and slightly lower pay,a firm is more likely to attract:

A)single employees.
B)married employees.
C)older or senior employees.
D)unskilled employees.

Question 22

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

A)the entire team 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.
D)some team members may perceive the team leader to be a role model.

Question 23

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)one must use as much information as possible to develop compensation contracts,even if the cost of obtaining the information is unreasonable.
C)one must only use information that is necessary 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 24

In the principal-agent model,at the employee's optimal effort choice:

A)the net benefits of effort are maximized.
B)the marginal costs of efforts exceed the marginal revenue.
C)the incentive coefficient of effort is very high.
D)the marginal benefit of effort is negative.

Question 25

Consider the salary of Mary Sue Nelson,a sales agent for Plain Truth Advertising.Her wage package is ,where Q is her dollar volume of sales.Her productivity is ,where e denotes her hours of effort and µ 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 26

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

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

Question 27

Dan Heath is the majority owner of Plain Truth Advertising.He hires Shirley Downs as the 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 28

In the single-period principal-agent model:

A)both the employer and the employee are risk-averse.
B)both the employer and the employee are risk-neutral.
C)the employer is risk-averse but the employee is risk-neutral.
D)the employer is risk-neutral but the employee is risk-averse.

Question 29

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 in comparison to an 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 30

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 is 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 31

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 32

Consider the salary of Mary Sue Nelson,a sales agent for Plain Truth Advertising.Her compensation package for a week is ,where Q is her dollar volume of sales.Her productivity is ,where e denotes her hours of effort and µ is a random variable with mean 0.She has an effort cost of .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 33

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 34

Incentive compensation schemes are more likely to be value enhancing if:

A)they are designed to minimize the principal's average cost.
B)they can accurately account for the dysfunctional behavior of the principal.
C)they are designed to limit the agent's gaming behavior.
D)they can minimize the administrative cost borne by the agent.

Question 35

Consider the salary of Mary Sue Nelson,a sales agent for Plain Truth Advertising.Her weekly compensation package is ,where Q is her dollar volume of sales.Her productivity is ,where e denotes her hours of effort and µ,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 36

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 37

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 a mixed record in success of incentive pay plans.
D)incentives must be non-monetary to work.

Question 38

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 39

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 low-wage countries.

Question 40

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

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