Designing Incentives: Agency Risks and Organizational Routines
Agency Theory: Incentives and Contract Risks
Systems of Incentives vs. Monitoring
Systems of incentives are a mechanism for the direct control of agency, serving as an alternative to monitoring.
Types of Motivation
- Extrinsic Motivation: Determined by the expected material profit or loss to be gained or avoided.
- Intrinsic Motivation: Occurs when the task itself is sufficiently encouraging for the person performing it.
Explicit and Implicit Incentives
Incentives based on an objective measure of performance are explicit incentives. These include:
- Individual incentives (easy for employees to understand).
- Group-based pay results.
Incentives based on a subjective assessment are implicit incentives.
Perfect and Incomplete Contracts
A contract is perfect or complete when all obligations are specified by the principal and agent, and the principal prevents risks.
Contracts are typically divided into two categories based on risk:
Risks Ex Ante (Pre-Contractual)
Risk incurred by disregarding information handled by the counterpart. This leads to the problem of adverse selection and anti-selection. This occurs, for example, where an employer is unaware of an aspect of the contractual party's life that can condition their performance.
Risks Ex Post (Post-Contractual)
Risk where the agent cannot meet the established agreements once the contract has been signed. This leads to moral hazard and the hold-up problem.
The problem of efficient contracting aims to solve the issue of incomplete contracts derived from limited rationality and information asymmetries, relying on spot market contracts and macro agreements.
Incentives and Organizational Behavior
Self-Interest and Opportunism Prevention
The pursuit of self-interest can be categorized:
- A weak search for self-interest implies difficulty internalizing organizational goals.
- A strong search implies a greater propensity to subordinate the company's goals to one's own.
Simple self-interest is what the person expects depending on their condition as an agent.
To prevent opportunism, mechanisms include incentives for meeting targets, standardization of processes, or supervision. However, these may yield the opposite result: pressure.
Categorization of Agents and Incentives
Based on the type of inducements and incentives used to link them to the company, agents are categorized as:
- Owner-Shareholders: Incentives are related to the conservation of firm value.
- Employees: Rewards are typically lower, consisting of material and immaterial rewards.
- Miscellaneous Agents: Rewards are derived from utility.
Organizational Design and Rationality
Organizational design acts upon the ability to make decisions, modifying the limits of the exercise of rationality profile area and the organizational context.
The company provides an organic organizational rationale, which results in organizational routines, including company laws and behavioral norms.
Determinants of Behavior in the Company
Behavior in the company is determined by:
- Limited Rationality.
- The area of exercise of rationality defined by the company (which is not permanent).
- Organic Rationality (which endures in the company).
- Willingness to cooperate.
- Incentives (which are not permanent).