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Summary Incentives & Control UVA lectures + papers
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A summary of the course Incentives & Control (UVA) including both the lectures and the papers. Next to this, the exam of 2020 is included with answers.
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I&C - week 1Two basic assumptions of economic models: greed (prefer more over less) and risk-aversion. With
greed, the utility increases with each additional unit of income, while with risk-aversion the utility
increases at decreasing rate with each additional unit of income.
Information asymmetry: not everyone have the same information (private information).
About what do we have information - hidden actions/effort or hidden characteristics.
- Moral hazard: hidden actions/effort + uninformed party moves first
- Screening / adverse selection: hidden characteristics + uninformed party moves first
- Signalling: hidden characteristics + informed party moves first
Moral hazard: agent has private information about effort choices, misalignment of interests between
principal and agent. Solution: principal elicits high effort and desired action choices by offering
contracts contingent on performance measures rewarding agents for productive effort (incentive
compensation contract).
Screening: agent has private information about characteristics. Principal induces agents to truthfully
reveal their private information about its type by offering contract beneficial for the high type, but
not for low type (dentist package in health insurance).
Signalling: agent communicate their type to principal by taking actions less costly to the high type,
but this requires credible communication about its type (separating equilibrium i.s.o. pooling
equilibrium) (education - higher education is more costly for lower type).
Knowledge and decision rights are important to make business decisions.
Knowledge however is often dispersed throughout the organization -- solution: moving knowledge to
those with decision rights (KTC - knowledge transfer cost) or moving decision rights to those with
knowledge (CC).
General knowledge: inexpensive to transmit.
Specific knowledge: costly to transfer - necessitates decentralization of decision rights.
-- Gives two problems: right assignment and control / agency.
Jensen & Meckling (1992) - partition decision-making rights throughout organization and create an
incentive system that provides measure of performance and specifies relationship between rewards
and punishment and performance measure outcomes.
Outside markets - not applicable for firms as employees do not receive rights to alienate decision
rights under their control.
- Markets have a system of private, alienable rights.
- Rights are now acquired by those who value the rights the most.
- Market prices reflect present value of future cash flows from current utilization and thus provide
rewards and punishment as a result of their decisions.
Optimal level of delegation is the trade-off between cost of poor information vs cost of inconsistent
objectives - breakdown of decision rights in e.g. initiation, implementation and monitoring rights.
Subsequently, provide rewards and punishments tied to performance measure outcomes.
Framework of Merchant & Van Der Stede
Result controls: define performance measures and reward good results.
Action controls: focus on employee behaviour to ensure that employees perform actions beneficial
,to the organization.
Personnel and cultural controls: based on self-control and social control.
Result controls: holding people accountable for their delivered results (through their actions),
important in settings of asymmetric information - facilitates empowerment as actions are not
constrained. Controllability principle: who is held accountable should also be able to influence the
results in a material way. Ex-post and ex-ante fashion.
Abernethy et al (2004)
Delegation of decision rights from the CEO towards divisional managers.
The use of divisional summary measures to address incentive & control problems (opposed to firm-
level measures and/or divisional specific measures).
Larger information asymmetry leads to a larger delegation of decision rights, which leads to a more
weighted use of divisional summary measures of performance (to ensure control). Interdependencies
lead to a decrease in delegation of decision rights and use of divisional summary measures -- less
incentive to cooperate, since only individual performance is evaluated.
Action controls: assumes the decisions and actions are observable for the superior manager and the
superior level knows which actions are desirable (direct supervision, action accountability - code of
conduct, pre-action review and behavioural and administrative constraints (passwords).
Advantage: codification of best practices, coordination incorporated in procedures.
Disadvantage: means-end inversion, deters creativity and innovation.
Personnel controls: built on self-control, intrinsic motivation, ethics. Employees have natural task
preferences that might be aligned with corporate objectives. Selection and placement / training and
job design and provision of resources.
Cultural controls: refers to shared norms and values, and social pressure exerted by groups on
individuals (codes of conduct, group-based rewards, intra-organizational transfers, physical and
social arrangements and tone at the top).
Incentive and control problems at corporate boards (lenders and investors -- CEO): presence of
asymmetric information and imperfect alignment of interest.
Jensen & Meckling (1976)
Focus on control problems due to separation of ownership and control prevalent in publicly held
firms.
- Investors (shareholders) delegate decision rights to corporate executives.
- Outside board members monitor executives on behalf of those shareholders (residual claimants).
- Debtholders monitor executives to assess likelihood of default.
Agency costs of equity: arise with delegation of decision rights from the shareholders towards the
CEO.
Manager who owns 100% of the shares: consumption of perks.
Manager who owns 95% of equity claims: manager will consume more perks (only 95% of costs).
Separation of ownership and control introduces agency problems (moral hazard), divergence of
interests between manager and outside investors since she bears only a fraction of the costs to
maximize her own utility by consuming perks.
Agency costs of equity:
- Monitoring costs of the principal: limit divergence of interest by incurring monitoring costs to limit
,deviant actions of the agent.
- Bonding costs by the agent: agent expends resources to guarantee that he will not take certain
actions that would harm the principal.
- Residual loss: resulting divergence of interest as it is not economically efficient to fully align
principal’s and agent’s interests.
Agency costs of debt: incentive effects associated with high leverage, monitoring costs that follow
from incentive effects and bankruptcy costs. In highly leveraged firms, owners have incentives to
adopt (risky) projects with high pay-off and low likelihood of success, lenders take this into account
when determining the cost of debt. Investors benefit from upside potential, but limited downside
potential due to limited liability (ratio equity/liability is important).
Lenders often restrict managerial actions by including provisions into debt covenants.
- Impose constraints on managerial actions about dividends, future debt issues and maintenance of
working capital.
- Covenants not complete given the costs of writing detailed contracts, potential adverse effects of
detailed covenants and unforeseen events.
- Costs of writing such contracts, enforcing them, residual divergence of interest also impounded in
cost of debt.
Control systems
Benefit: higher likelihood organizational objectives and strategies will be accomplished.
Costs: direct ‘out-of-pocket’ costs of bonuses paid, time allocated to execution of control procedures,
time devoted to revising incentive and control system, indirect costs associated with harmful side-
effects.
Typically cost-efficient to accept probability of divergent behaviour of employees (residual loss).
Tightness of control system (high level of assurance that organizational objectives and strategies will
be accomplished) may increase benefits, but may also increase the cost of control.
Contingency theory: there is no universally best incentive and control system that applies to all
situations and organizations.
Sandino (2007) - what kind of initial control systems do early-stage firms adopt?
To what extent drives a specific purpose the introduction of individual control systems: minimize
cost, enhance revenue and minimize risk (and basic controls)?
Is the type of initial control system associated with the firm’s strategy (cost leadership - minimizing
costs vs. differentiation strategy - differentiating the product in the perception of the customer)?
Do firms with fit between control system design and firm’s strategy exhibit higher performance?
Basic control systems like pricing and budget are used in almost all firms.
Firms adapt controls that are in line with the strategy, when the control system is fitting than it is
deemed useful and it will improve the performance.
When the strategy is different than increasing revenue or decreasing costs, the control system gets
more specific and only then the contingency theory is in place.
Classification of cultures (Hofstede, 1984): power distance, individualism vs. collectivism, uncertainty
avoidance, masculinity vs. femininity and long-term orientation.
Grabner & Moers (2013)
Contingency theory applies reductionist approach where MC practices are independent of other MC
, practices such that individual MC practices can be examined in isolation.
- Management control as a package
Complementarities: given that we typically find clusters of organizational practices. Increasing one
practice increases the returns of increasing the other MC practices.
Polar side: substitutes where one MC practice decreases returns of other practices.
Management control as system: implication is firms select control practices that are internally
consistent (exploit interdependencies) while they also match contingencies that they face.
Productivity equation: are MC practices more productive when adopted jointly versus are MC
practices more often adopted jointly.
Contingency (MC fit context, looking at elements individually) vs. complementarities (MC fit
together).
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