Incentives and managerial effort under competitive pressure: An experiment

We investigate how increased competition affects firm owners׳ incentives and managers׳ efforts in a laboratory experiment. Each owner offers a compensation scheme to his manager in two different conditions: under monopoly and under Cournot duopoly. Following acceptance of the compensation, the manager chooses an effort level to increase the probability of a cost-reduction which affects the firm׳s profit. According to standard theoretical predictions the entry of a rival firm in a monopolistic industry affects negatively both the incentive compensation and the effort level. Our experimental findings show that the entry of a rival firm has two effects on managerial effort: an internalization effect which affects positively the level of effort and an income effect which has a negative impact on effort. The combined outcome of these two effects is neutral with respect to managerial effort: we observe that when competition reduces the firm׳s profit, the owner reacts by offering lower incentives but despite the lower incentives the manager still accepts the contract offer and exerts the same level of effort than under the monopoly condition.     

Minimum payments and induced effort in moral hazard problems

Consider a moral hazard problem in which there is a constraint to pay the agent no less than some amount m. This paper studies the effect of changes in m on the effort that the principal chooses to induce from the agent. We present sufficient conditions on the informativeness of the signal observed by the principal and on the agentʼs utility under which when m increases, induced effort (and hence productivity) falls. We also study how the cost minimizing contract for any given effort level varies in m. We present an efficient algorithm for numerically calculating optimal contracts for given parameters and show that induced effort falls when m is increased in many cases even when our sufficient conditions fail.     

Joint production in teams

Consider Holmström's moral hazard in teams problem when there are n agents, each agent i has an a_i-dimensional strategy space and output is m-dimensional. We show that a compensation mechanism that satisfies budget balance, limited liability and implements an efficient allocation generically exists if and only if . Moreover, under a weak additional condition, the equilibrium implemented by this mechanism is unique in the class of pure strategy Coalition-Proof equilibria.     

Why do firms adopt CEO stock options? Evidence from the United States

This paper examines the determinants of stock option introduction as a part of CEO compensation in listed US firms during the 1994–2004 period. The results are consistent with agency costs and recruiting considerations, suggesting that firms do not adjust CEO compensation in order to address the ‘investment horizon’ problem. The findings also suggest that CEO stock option adoption is not necessarily influenced by the same factors that have been found in the literature to affect the level of CEO stock option compensation and the adoption of broad-based stock option incentives. Overall, the findings provide evidence for several theoretical predictions, thus adding to our understanding of managerial incentives.     

股权激励与财务重述——基于中国A股市场上市公司的经验证据

本文以2005—2007年中国A股市场实施股权激励的上市公司及其配对样本为研究对象,采用Logistic回归法,考察了股权激励与财务重述的相关关系。研究发现,实施股权激励的公司发生财务重述的可能性要显著高于未实施股权激励的公司;相比基于业绩的股权激励模式,实施基于股价的股权激励模式的公司发生财务重述的可能性更高。研究结论支持了有股权激励尤其有基于股价的股权激励模式的上市公司经营者可能有短期盈余操纵行为的观点。     

Reputation for quality and adverse selection

We analyze a dynamic market with a seller who can make a one-time investment that affects the returns of tradable assets. The potential buyers of the assets cannot observe the seller׳s investment prior to the trade or verify it in any way after the trade. The market faces two types of inefficiency: the ex-ante inefficiency, i.e., the seller׳s moral hazard problem, and the ex-post inefficiency, i.e., inefficient ex-post allocations due to the adverse selection problem. We analyze how the observability of information by future buyers, through which the seller builds a reputation, affects the two types of inefficiency as well as the interplay between them.     

Options can induce risk taking for arbitrary preferences

Summary. It is widely believed that call options induce risk-taking behavior. However, Ross (2004) challenges this intuition by demonstrating the impossibility of inducing managers with arbitrary preferences to always act as if they were less risk averse. If preferences and price distributions are unknown, risk-taking behavior cannot be always induced by an option contract. Here, we prove a new result showing that, with no information about preferences and some knowledge about prices, one can write a call option that makes all managers prefer riskier projects to safer ones. This points out that in order to design options that induce risk taking it is sufficient to have information about price distributions.Received: 5 November 2003, Revised: 1 November 2004, JEL Classification Numbers: D81, G00, J33, M21. Correspondence to: Luis H.B. BraidoWe thank Renée Adams, Heitor Almeida, Carlos E. da Costa, Andrew Horowitz, Paulo K. Monteiro, Walter Novaes, Sergio O. Parreiras, Rodrigo R. Soares, and especially Marcos Tsuchida for many helpful comments.     

Conflicting tasks and moral hazard: Theory and experimental evidence

We study a multi-task principal-agent problem in which tasks can be in direct conflict with each other. In theory, it is difficult to induce a single agent to exert efforts in two conflicting tasks, because effort in one task decreases the success probability of the other task. We have conducted an experiment in which we find strong support for the relevance of this incentive problem. In the presence of conflict, subjects choose two efforts significantly less often when both tasks are assigned to a single agent than when there are two agents each in charge of one task.     

Risk allocation and uncertainty: some unpleasant outcomes of financial innovation

Financial innovation introduces the possibility of exchange on wider time-events sets. In this way, market incompleteness should be reduced with an overall advantage. The existence of this advantage also depends on other elements, like the degree of market competition, the level of information, and the presence of inefficiencies generated by moral hazard. One kind of behavior which has been widely common among banks consists in the reduction of risk taking in relation to credit activity. Credit risk tends to be covered through the packaging of credits into securities. This situation means that since the bank is not shouldering the risk, it does not invest in the acquisition of knowledge regarding the borrower, but only regarding his/her generic characteristics which are reflected in the evaluation of the assets in which the credits are packaged. Moreover, financial innovation was developed, in particular by investment banks, with non-standardized products, exchanged over-the-counter, and substantially lacking secondary markets. The greatest problems derive from the low liquidity of these products and from the uncertainty over their returns. This is why it would be good to stimulate the introduction of standardized products, whose risks are easy to determine, to be exchanged on organized markets, instead of complex products, which are substantially illiquid and exchanged over-the-counter.

The wealth effects of premium subsidies on moral hazard in insurance markets

Insurance premium subsidies are present in many insurance markets. The Swiss government, for example, paid out CHF 4.26 billion or 0.72% of the Swiss GDP for health insurance premium subsidies in 2011. Analyses of premium subsidies have often highlighted that the increased insurance demand due to premium subsidies increases the effects of moral hazard in the market. Other consequences of premium subsidies, however, have mostly been neglected by the literature. We show in our theoretical model that the wealth effects of premium subsidies decrease the sensitivity of the insured towards the monetary consequences of losses. This leads to less prevention efforts by the insured and thus increases moral hazard in the market. The effect is preserved if the subsidy is financed through proportional taxation. Using two alternative models, we show that providing state-dependent subsidies can either increase or reverse this effect, depending on which state subsidies are paid. We argue that whether demand effects or wealth effects of premium subsidies will dominate the insured׳s behavior depends on the market structure.     

Contests to become CEO: incentives, selection and handicaps

Should a firm favor insiders (handicap outsiders) when selecting a CEO? One reason to do so is to take advantage of the contest to become CEO as a device for providing current incentives to employees. An important reason not to do so is that this can reduce the ability of future CEOs and, hence, future profits. The trade-off between providing current incentives and selecting the most able individual to become CEO is the focus of this paper. If insiders are good enough (better or nearly as good as outsiders), incentive provision to insiders typically dominates and it is optimal to handicap outsiders, sometimes so severely that they have no chance to win the contest. However, if outsiders are sufficiently better than insiders, selection dominates and it is the insiders who are severely handicapped. This finding is in sharp contrast to the existing literature which has so far ignored this trade-off. In all, our model provides useful insight into contests to become CEO and rationalizes empirical regularities in the source of CEOs chosen by firms. In particular, our analysis helps to explain the lower tendency of firms in more heterogeneous industries and firms with a product or line of business organizational structure to select an outsider as CEO.     

Asymmetric awareness and moral hazard

This paper introduces asymmetric awareness into the classical principal–agent model and discusses the optimal contract between a fully aware principal and an unaware agent. The principal enlarges the agentʼs awareness strategically when proposing a contract and faces a tradeoff between participation and incentives. Leaving the agent unaware allows the principal to exploit the agentʼs incomplete understanding of the world, relaxing the participation constraint, while making the agent aware enables the principal to use the revealed contingencies as signals about the agentʼs action choice, relaxing the incentive constraint. The optimal contract reveals contingencies that have low probability but are highly informative about the agentʼs effort.     

Managerial overload and organization design

This paper considers a firm's choice between a “divisional structure” and a “functional structure.” It shows that an increase in the number of projects which the firm can adopt creates a managerial overload, which favors the divisional structure.     

Fairness and Incentives in a Multi‐task Principal–Agent Model

This paper reports on a two‐task principal–agent experiment in which only one task is contractible. The principal can either offer a piece‐rate contract or a (voluntary) bonus to the agent. Bonus contracts strongly outperform piece‐rate contracts. Many principals reward high effort on both tasks with substantial bonuses. Agents anticipate this and provide high effort on both tasks. In contrast, almost all agents with a piece‐rate contract focus on the first task and disregard the second. Principals understand this and predominantly offer bonus contracts. This behavior contradicts the self‐interest theory but is consistent with theories of fairness.     

Agency theory: choice-based foundations of the parametrized distribution formulation

This paper develops choice-theoretic foundations of the principal’s and the agent’s behaviors underlying the parametrized distribution formulation of agency theory. Both the principal and the agent are expected-utility maximizers and their action-dependent subjective probabilities are defined directly on the outcomes. The results are used to evaluate and interpret the common prior assumption. I am grateful to Simon Grant and, in particular, to Peter Wakker for their comments and suggestions, and to the NSF for financial support under grant SES-0314249.     

Coexistence of long-term and short-term contracts

We study the length of agreements in a market in which infinitely-lived firms contract with agents that live for two periods. Firms differ in the expected values of their projects, as do workers in their abilities to manage projects. Worker effort is not contractible and worker ability is revealed during the relationship. The market dictates the trade-off between sorting and incentives. Short- and long-term contracts often coexist: The best firms always use short-term contracts to hire high-ability senior workers, firms with less profitable projects use short-term contracts to save on the cost of hiring junior workers, whereas intermediate firms use long-term agreements to provide better incentives to their workers. We relate our results to the optimal assignment literature that follows Becker (1973).     

Team production with inequity-averse agents

This paper analyzes the efficiency of team production when risk-neutral agents exhibit other-regarding preferences. It is shown that full efficiency can be sustained as an equilibrium of a budget-balancing mechanism that punishes some randomly chosen agents if output falls short of the efficient level but distributes output equally otherwise. The result depends on agents being sufficiently inequity-averse.

Linear contracts as incentives: a puzzle

This paper reexamines the linear schedule of compensation as a tool for providing incentives to managers when contractible output is a function of costly effort and a random shock. Two puzzling situations compatible with linear schemes of compensation are presented. First, if the model parameters are such that the optimal participation on output is below 50%, the variable compensation turns out to have a negative effect on manager’s utility. Second, if it is below 25%, linear incentives allow situations in which larger utilities are reached by means of smaller rewards.      

Ranking of information systems in agency models: an integral condition

Summary. We provide a condition for ranking of information systems in agency problems. The condition has a straightforward economic interpretation in terms of the sensitivity of a cumulative distribution with respect to the agent's effort. The criterion is shown to be equivalent to the mean preserving spread condition on the likelihood ratio distributions. Received: November 10, 1999; revised version: February 17, 2000     

Dynamic market for lemons with endogenous quality choice by the seller

We analyze a dynamic market for lemons in which the quality of the good is endogenously determined by the seller. Potential buyers sequentially submit offers to one seller. The seller can make an investment that determines the quality of the item at the beginning of the game, which is unobservable to buyers. At the interim stage of the game, the information and payoff structures are the same as in the market for lemons. Our main result is that the possibility of trade does not create any efficiency gain if (i) the common discounting is low, and (ii) the static incentive constraints preclude the mutually agreeable ex-ante contract under which the trade happens with probability one. Our result does not depend on whether the offers by buyers are private or public.