Pay for Performance

Organisations wants workers to work hard and put in effort. How will they achieve this?

Encouraging Optimal (First-Best) Behaviour - TLDR: incentives
 * The organisation has to induce workers to make decisions that will benefit the organisation
 * Making decisions, solving outcomes, how much to put in effort, what projects to pursue all incur personal benefits and costs to the worker.
 * Benefits and costs of workers are benefits and costs to the organisation.
 * Optimal behaviour maximises value. Organisations should try to achieve this by maximising worker benefits and minimising worker costs.
 * This is maximising total surplus w - c
 * Incentives such as bonuses can be used to induce first-best behaviour if profit is perfectly observable
 * General Contracting Principle - Pay to Play
 * Residual Claimant, worker receives all the remaining renumeration after products/service being paid.
 * Set piece rate to profit margin and lower the wage.
 * Possible if not risk averse, not financially constrained, there is good performance measure and knows what actions maximises surplus.
 * May even make the worker pay to work.

Cost of providing incentives
 * Measuring performance
 * How do you measure performance of workers correctly and accurately?
 * If performance measures are poor indicators of a worker's behaviour it is hard to apply pay for performance.
 * Firm may be unaware about what to pay to increase performance and not know what to measure.
 * eg: a1 = customer service, a2 = customer support
 * Pi = effort a1 + effort a2 + e(random noise)
 * P(a1, a2) = effort a1 + effort a2*g(responsiveness of effort). Firm does not see the individual effort but a sum instead.
 * Firm gets Pi - wage - bonus*measurementP = Pi - w - bP
 * Worker gets wage + bonus*measurementP - C(a1, a2) = w + bP - C(a1,a2)
 * C(a1, a2) is personal cost function with a1 and a2 are the type of effort the workers put in
 * MAXIMISE w + bP(a1, a2) - C(a1,a2)
 * find a1 and a2 in terms of bonus, b
 * Worker will PARTICIPATE if w + bP(a1, a2) - C(a1,a2) >= u
 * Therefore minimum to make worker participate is w = u + bP(a1, a2) + C(a1,a2)
 * differentiate d(a1+a2) by bonus, b to find marginal benefit of higher bonus
 * differentiate C(a1, a2) by bonus, b to find marginal cost of higher bonus
 * Optimal bonus = marginal benefit of higher bonus/marginal cost of higher bonus
 * Profit depends on how well the bonus is aligned with the profits, not how responsive the profit is to the bonus
 * Multitasking can be a problem. Raise the cost of doing other activities while increasing bonus of preferred activity.
 * P = a1 + e
 * Pi = a1 + a2 + e
 * Worker willing to put in a1 + a2 = 2A and a1 = A effort
 * Interdependent tasks C(a1,a2) = 1/2*(a1-A)^2 + y/2*(a1+a2-A)^2
 * if y>0 task 1 and 2 and substitutes with more effort in a1 raising marginal cost of a2
 * if y<0 task 1 and 2 are compliments with more effort in a1 reducing marginal cost of a2
 * In absence of performance pay, workers will put equal effort into both a1 and a2.
 * Worker will choose to allocate effort more optimally when bonus bP is paid. Profits will increase with more effort in one task then another.
 * When tasks are substitutes, rewarding one task reduces incentive to do another.
 * When task 1 becomes more profitable, workers will do less of the task 2 and attempt to reduce the cost of profitable task by lowering effort on task 2
 * When faced with multiple tasks, workers will only perform the tasks that are rewarded
 * If task 2 gives profit than the other but can only pay for task 1, don't do performance pay at all.


 * How to get around poor performance measure
 * balance incentives
 * better job design
 * set firm boundaries
 * reduce incentives and monitor better


 * Financial constraints
 * How much to do you pay the workers to get them to put in effort?
 * If workers do not like variability in pay and are financially constrained(can't pay to work) then incentives are hard to implement.
 * If the workers can't pay the firm to work firm can't capture the total value charging the worker
 * When there are no financial constraints, the performance measure P = Profit, Pi
 * Increasing bonus in this case will lower profits
 * Solution
 * Hire less constrained workers
 * Set piece rate below gross profit margin
 * Facilitating Finance
 * Compensation risk
 * Most workers are risk averse ~> care about expected pay and fluctuations in pay
 * Most firms are risk neutral
 * Increase in piece rate makes the risk averse worker's risk costs larger
 * This makes it costly to provide incentives
 * Solution
 * Set piece rate below gross profit margin
 * Set higher price, the more product the worker is, the less risk averse the worker is and the less noisy the performance measure is
 * Hire less risk averse workers
 * Reduce noise(reduce complication?) in performance measure
 * Adaptation costs
 * What if the workers start demanding more and more benefits?
 * Firm doesn't know what to do but worker knows more about what to do to benefit the organisation.
 * How do you get the worker to act on this?

Hidden Dangers of Performance Pay
 * Faking performance improvements
 * Sabotage other workrs
 * Reducing performance now so as to increase performance later for better pay, the Ratchet effect
 * Solution: Solving commitment issues. Put in piece rates so that workers can get commissions straight from the beginning. Don't let them hold back

Indirect effect of Performance Pay: Selection
 * Filters out unmotivated and lazy workers.
 * More motivated and talented workers stay and apply while the rest leave or do not apply

Question solving
 * Compare wage+bonus-personal cost to wage
 * Expected utitlity is the maximum between bonus-cost or zero + wage
 * To find minimum bonus willing to work for divide personal cost by effort measurement(P)