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Why Do Firms Use Incentives That Have
No Incentive Effects?




                 Paul Oyer
                 Stanford University
                 Graduate School Of Business


                                               1
Incentives

  Almost no incentive system is strictly
  about incentives (on-the-job behavior)
  Incentives affect hiring
  And they affect retention
  In fact, some “incentives” are ONLY
  about hiring and retention


                                           2
The Power of Incentives

 Sales Commissions
 CEO Pay
 Other examples
   Piece rates in manufacturing
   Windshield Installers
   Tree Planters and Fruit Pickers
 Common Thread – Tied to Individual
 Performance
                                      3
Key Problem #1: Groups

 Software Engineers
 Marketing Managers
 Management Consultants



                          4
Key Problem #2: “Distortion”

  Piece Rates → Quality
  Problems
  Salespeople make promises or
  lower price to meet quota
  “Teaching to the Test”
  Doctors take “easy” cases to
  improve report cards
                               5
Key Problem #3: Risk

 People prefer sure things
 Firms have to compensate for
 risk
 For example, sales
 commissions are higher in
 uncertain environments
                                6
Good Incentives

 Based on measures that are closely
 related to things the employee can
 affect
 Closely related to the firm’s ultimate
 goals (cannot be “distorted”)



                                          7
Why Group Incentive?

 Many “incentives” are at a group level
   Broad-Based stock and option plans
   Profit sharing
   Bonus pools based on firm success
 While not easily distorted, can
 employees affect these measures?


                                          8
A Simple Example
 A medium/large (several thousand
 employees) Silicon Valley company gives
 stock options to all employees
 Let’s call this company “Acme”
 New MBAs get options worth over $200K
 If that employee takes an action that
 increases firm value by $1million, he/she
 gets $29
 Good management would use more efficient
 means to encourage effort
                                         9
Why Use These Incentives?

 Sorting
   Who will accept this compensation?
 Retention
   Flexible compensation costs
   Keeps people when you want them




                                        10
Sorting: A Simple Example
 Safelite Glass installs car windshields
 Individual installers do on-site work
 Firm switched from hourly pay to piece rate;
 Productivity increased about 40%
 Half of this was due to people working
 harder
 The other half was due to “Sorting”
   More productive people applied
   Less productive people left

                                            11
Sorting and Group Incentives

 Can this explain broad-based stock
 plans?
 Who is attracted to stock options?
   Optimists – Those who believe in
   company/industry
   Risk Takers
   Suckers?

                                      12
Retention & Group Incentives

 Think of the new MBA making
 $100K/year
   Option grant of $200K upon taking job
   Options vest ¼ per year
   If Acme stock is flat or down for four
   years, worth nothing
   If stock doubles in 4 years, employee
   nets $500K
                                            13
Retention

 If Acme did NOT use options, it might
 pay the employee $140K/year
 Costs the firm $5-10K/year to
 compensate employee for risk
 If options don’t create incentives, what
 does Acme get for it’s money?


                                            14
Retention

 Options vest over four years.
 Employee is tied to Acme.
 But Acme can make anything vest.
 For example, put some money in a
 savings account and give it to
 employee after 4 years.
 After all, that’s what pensions are.
 So why options?
                                        15
Retention

 Because option value fluctuates with 2
 things
   Value of employee to Acme
   Value of the employee to Acme’s
   competition




                                      16
Retention
 Suppose the economy takes off in the first
 year employee is at Acme
 Stock is up 25%
 Employee gets attractive and tempting
 offers
 She can realize about $30K if she leaves
   But, even if stock is flat for the next three years,
   she leaves $100K “on the table”
   Also, she gives up $270K of “option value”

                                                          17
Retention

 Unvested option value tracks her labor
 market value
 Increased temptation to leave
 automatically countered by increased
 incentive to stay



                                      18
Retention

 What if the economy does poorly in
 that first year?
 Suppose stock price is down 25%
 New engineers now available for
 $125K in cash and options
 She isn’t receiving attractive offers


                                         19
Retention

 Acme faces cost pressure
 May want to cut wage expenses
 But the market has actually done that
 for them!
 Firm paying below current market
 wage
 Employee lost half her option value
 Firm avoids layoffs and pay cuts!
                                         20
When Will This Work?

 Firm-based “incentives” can be
 effective for retention when
   Labor market wages correlated with
   firm’s stock price
   Workers are not too risk averse
   Changing jobs is easy for employees but
   costly for firms


                                             21
Why It Works in Silicon Valley

  Fluid labor market – skill is not “firm
  specific”
  Many local employers with similar
  needs
  Firms’ fortunes (and wage offers) rise
  and fall together


                                            22
When Won’t it Work?

 Firms that are unusual in their area
   Coke employees in Silicon Valley
   Microsoft employees in Dayton
 When many workers are risk averse
 (for example, big mortgages)
 When workers are already tied to the
 firm

                                        23
Summary

 Incentives are not just about incentives
 ALL incentives affect selection and
 retention
 Group “incentives” often are ONLY for
 selection and retention
 Choose any incentive plan wisely – tie
 measures to employee “inputs”
                                        24

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Why Firms Use Incentives That Have No Incentive Effects

  • 1. Why Do Firms Use Incentives That Have No Incentive Effects? Paul Oyer Stanford University Graduate School Of Business 1
  • 2. Incentives Almost no incentive system is strictly about incentives (on-the-job behavior) Incentives affect hiring And they affect retention In fact, some “incentives” are ONLY about hiring and retention 2
  • 3. The Power of Incentives Sales Commissions CEO Pay Other examples Piece rates in manufacturing Windshield Installers Tree Planters and Fruit Pickers Common Thread – Tied to Individual Performance 3
  • 4. Key Problem #1: Groups Software Engineers Marketing Managers Management Consultants 4
  • 5. Key Problem #2: “Distortion” Piece Rates → Quality Problems Salespeople make promises or lower price to meet quota “Teaching to the Test” Doctors take “easy” cases to improve report cards 5
  • 6. Key Problem #3: Risk People prefer sure things Firms have to compensate for risk For example, sales commissions are higher in uncertain environments 6
  • 7. Good Incentives Based on measures that are closely related to things the employee can affect Closely related to the firm’s ultimate goals (cannot be “distorted”) 7
  • 8. Why Group Incentive? Many “incentives” are at a group level Broad-Based stock and option plans Profit sharing Bonus pools based on firm success While not easily distorted, can employees affect these measures? 8
  • 9. A Simple Example A medium/large (several thousand employees) Silicon Valley company gives stock options to all employees Let’s call this company “Acme” New MBAs get options worth over $200K If that employee takes an action that increases firm value by $1million, he/she gets $29 Good management would use more efficient means to encourage effort 9
  • 10. Why Use These Incentives? Sorting Who will accept this compensation? Retention Flexible compensation costs Keeps people when you want them 10
  • 11. Sorting: A Simple Example Safelite Glass installs car windshields Individual installers do on-site work Firm switched from hourly pay to piece rate; Productivity increased about 40% Half of this was due to people working harder The other half was due to “Sorting” More productive people applied Less productive people left 11
  • 12. Sorting and Group Incentives Can this explain broad-based stock plans? Who is attracted to stock options? Optimists – Those who believe in company/industry Risk Takers Suckers? 12
  • 13. Retention & Group Incentives Think of the new MBA making $100K/year Option grant of $200K upon taking job Options vest ¼ per year If Acme stock is flat or down for four years, worth nothing If stock doubles in 4 years, employee nets $500K 13
  • 14. Retention If Acme did NOT use options, it might pay the employee $140K/year Costs the firm $5-10K/year to compensate employee for risk If options don’t create incentives, what does Acme get for it’s money? 14
  • 15. Retention Options vest over four years. Employee is tied to Acme. But Acme can make anything vest. For example, put some money in a savings account and give it to employee after 4 years. After all, that’s what pensions are. So why options? 15
  • 16. Retention Because option value fluctuates with 2 things Value of employee to Acme Value of the employee to Acme’s competition 16
  • 17. Retention Suppose the economy takes off in the first year employee is at Acme Stock is up 25% Employee gets attractive and tempting offers She can realize about $30K if she leaves But, even if stock is flat for the next three years, she leaves $100K “on the table” Also, she gives up $270K of “option value” 17
  • 18. Retention Unvested option value tracks her labor market value Increased temptation to leave automatically countered by increased incentive to stay 18
  • 19. Retention What if the economy does poorly in that first year? Suppose stock price is down 25% New engineers now available for $125K in cash and options She isn’t receiving attractive offers 19
  • 20. Retention Acme faces cost pressure May want to cut wage expenses But the market has actually done that for them! Firm paying below current market wage Employee lost half her option value Firm avoids layoffs and pay cuts! 20
  • 21. When Will This Work? Firm-based “incentives” can be effective for retention when Labor market wages correlated with firm’s stock price Workers are not too risk averse Changing jobs is easy for employees but costly for firms 21
  • 22. Why It Works in Silicon Valley Fluid labor market – skill is not “firm specific” Many local employers with similar needs Firms’ fortunes (and wage offers) rise and fall together 22
  • 23. When Won’t it Work? Firms that are unusual in their area Coke employees in Silicon Valley Microsoft employees in Dayton When many workers are risk averse (for example, big mortgages) When workers are already tied to the firm 23
  • 24. Summary Incentives are not just about incentives ALL incentives affect selection and retention Group “incentives” often are ONLY for selection and retention Choose any incentive plan wisely – tie measures to employee “inputs” 24