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)