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178. 307 Markets, Firms and Consumers Lecture 3 - Human Resource Management 178. 307 Markets, Firms and Consumers Lecture 3 - Human Resource Management

Overview l Background Readings – – l l 5: p 126 -32, 154 -59 Overview l Background Readings – – l l 5: p 126 -32, 154 -59 6: p 167 -70, 179 -83 8: p 250 -54 Chapters 12 -13 Peter Earl Canice Prendergast l Key Concepts – – – Bounded Rationality. Incomplete Contracts Signalling Moral Hazard Principal-Agent Theory Shirking Efficiency Wages

Human Resource Management l Principal-Agent Theory – – – At least 2 parties to Human Resource Management l Principal-Agent Theory – – – At least 2 parties to the contract The agent has different preferences to the principal Monitoring is costly Agency Theory Workers Managers

Why Can’t Contracts Eliminate Principal -Agent Problem? l Bounded Rationality – – l l Why Can’t Contracts Eliminate Principal -Agent Problem? l Bounded Rationality – – l l Contrast with global rationality Earl p 720 -74 Originates with Simon People seek satisficing solutions l Incomplete Contracts arise from – – Bounded rationality Unforseen circumstances Costly contracting and calculating Imprecision of language

Incomplete Contracts l Incomplete Contracts arise from – – Bounded rationality Unforseen circumstances Costly Incomplete Contracts l Incomplete Contracts arise from – – Bounded rationality Unforseen circumstances Costly contracting and calculating Imprecision of language

Signalling l l Signalling can mitigate incomplete contracts Agents have private information they are Signalling l l Signalling can mitigate incomplete contracts Agents have private information they are unwilling to reveal Players may use signals instead to indicate their true type Spence & Education Workers q. L (1 -q)H MP=1 MP=2 Average MP= q + 2(1 -q) = w

Imitative Strategies: Monarchs and Viceroys Imitative Strategies: Monarchs and Viceroys

Now introduce education l l l For L, c. L = y For H, Now introduce education l l l For L, c. L = y For H, c. H = ½y Define a critical value of y* – – If y ≥ y*, w = 2 If y < y*, w = 1 Non-imitation Condition 2 -c. Ly* < 1 2 -c. Hy* > 1 Type L chooses y=0 Type H chooses y=y*

Signalling Equilibrium c. L Wage 2 c. H 1 1 y* 2 Education- y Signalling Equilibrium c. L Wage 2 c. H 1 1 y* 2 Education- y

Moral Hazard l Definition – – Post-contractual opportunism Workers shirk Managers exaggerate difficulty of Moral Hazard l Definition – – Post-contractual opportunism Workers shirk Managers exaggerate difficulty of tasks These are instances of Principal-Agent problems l l l Shirking “Hardly a competent worker can be found who does not devote a considerable amount of time to studying just how slowly he can work and still convince his employer that he is going at a good pace” Taylor

Shirking Game Principal Strategies I NI S 0, -h w, -w W w-g, v-w-h Shirking Game Principal Strategies I NI S 0, -h w, -w W w-g, v-w-h w-g, v-w Agent

Solutions l l l h is inspection cost g is effort from working w Solutions l l l h is inspection cost g is effort from working w is wages v is value of output g>h>0 w>g l l There is no pure strategy equilibrium to this game. There is a mixed strategy – – p* = h/w q* = g/w

Examples of Shirking l Air-Traffic Controllers – l Changes in the early 70 s Examples of Shirking l Air-Traffic Controllers – l Changes in the early 70 s made disabilities easier to claim l Managerial Misbehaviour – – Counterintuitive Results – – 5+ years experience more likely to ‘punch out’ System errors increase in ‘light periods’. – Takeovers threaten poor managers Managerial resistance to takeovers common. Poison pills may be adopted. l l Rights to buy shares at low prices Poison pills reduce share value.

Efficiency Wages l l l Why aren’t workers taken on at lower wages? Suppose Efficiency Wages l l l Why aren’t workers taken on at lower wages? Suppose workers can put forward a positive effort e>0, or shirk e=0. Probability of detecting shirking is x l The worker’s utility is:

No Shirking Conditions l l l The firm must pay more than the alternative No Shirking Conditions l l l The firm must pay more than the alternative wage and the cost of effort (e) It is a solution to shirking Social cost is unemployment and foregone production

Other Compensation Schemes l l Explicit Incentive Pay Piece rates – – l l Other Compensation Schemes l l Explicit Incentive Pay Piece rates – – l l l Advantages Disadvantages Sales Commissions Pay for Skills Performance Pay l Group Incentives – – – Profit Sharing Gain sharing Effectiveness of Group Incentive Contracts l – Risk sharing Pay equity

Managerial Compensation l Motivating Risk Taking – – – l The puzzle Human capital Managerial Compensation l Motivating Risk Taking – – – l The puzzle Human capital risk Inducing risk-taking Paying for investment proposals Deferred compensation Other issues- Franchising

References l Economics and Psychology: A Survey Peter E. Earl The Economic Journal 100(402): References l Economics and Psychology: A Survey Peter E. Earl The Economic Journal 100(402): (Sep. , 1990), pp. 718 -755 http: //links. jstor. org/sici? sici=0013 -0133%28199009%29100%3 A 402%3 C 718%3 AEAPAS%3 E 2. 0. CO%3 B 2 -I l The Provision of Incentives in Firms Canice Prendergast Journal of Economic Literature > Vol. 37, No. 1 (Mar. , 1999), pp. 7 -63 http: //links. jstor. org/sici? sici=0022 -0515%28199903%2937%3 A 1%3 C 7%3 ATPOIIF%3 E 2. 0. CO%3 B 2 -%23 l Incentive Conflicts and Contractual Restraints: Evidence from Franchising James A. Brickley Journal of Law and Economics > Vol. 42, No. 2 (Oct. , 1999), pp. 745 -774 http: //links. jstor. org/sici? sici=0022 -2186%28199910%2942%3 A 2%3 C 745%3 AICACRE%3 E 2. 0. CO%3 B 2 -6