Explicit vs. Implicit Incentives

Margaret Meyer

Nuffield College, Oxford

2010

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Explicit incentives - provided through explicit contractual commitments by principal (P )

Implicit incentives - arise when a principal (e.g. a firm) or principals (e.g. firms competing in

a labor market) have some ex post discretion how to respond to agent’s (A’s) performance; A has

implicit incentives to change performance to influence P ’s discretionary decision

Different mechanisms/settings giving rise to implicit incentives

= different models of incentives deriving from a concern with “reputation”:

1. Self-enforcing contracts (=relational contracts)

2. Learning about A’s intrinsic characteristics

Applications of these ideas:

− incentives for employees (within firms)

− incentives for suppliers (between firms or between firms and consumers)

− incentives for public servants (within or between orgns.)

− more generally, incentives for individuals to behave in a manner which is different from that

which is in their short-run self-interest

N.B.: Implicit incentives may encourage or discourage “cooperative” (efficient) behavior

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1. Self-enforcing contracts (=relational contracts)

— infinitely-repeated interaction; select one eqm. among many

— no learning about A’s intrinsic characs.

— applications to:

− incentives for employees: Bull, QJE, 1987; MacLeod and Malcomson, Etrica, 1989, andAER, 1998; Baker et al, QJE, 1994; Levin, AER., 2003, and QJE, 2002.

− incentives for suppliers: Klein and Leffler, JPE, 1981; Baker et al, QJE, 2002.− See Malcomson (2010) for a comprehensive overview.

a. Simple model of “pure” implicit incentives (Baker, Gibbons, and Murphy (BGM)

(94))

— risk-neutral A privately chooses e each period at cost c(e)

— e stochastically determines A’s contribution to firm value, y ∈ {0, 1}— P (y = 1 | e) = e, P (y = 0 | e) = 1− e

— y is not verifiable (objectively measurable), so cannot be made the basis of an explicit

contract

— but y can be observed by both firm and worker (A) and used as basis for an implicit contract

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Pure implicit incentives

Contract: base salary s if A turns up - verifiable, so contractible

bonus b to be paid when y = 1 (this is the implicit component of the contract)

If A trusts firm to pay bonus iff y = 1, then A chooses e s.t. b = c0(e).

Firm will choose lowest s that induces A to participate.

A relationship with known finite horizon would “unravel”: firm would never pay bonus b, so A

would never supply effort. So consider an infinitely-repeated relationship.

Consider cooperation supported by trigger strategies:

• Firm and worker begin by cooperating (i.e. worker chooses e s.t. c0(e) = b, and firm pays b iff

y = 1). They continue to cooperate unless firm ever defects, in which case they both refuse to

cooperate forever after (i.e. worker chooses e = 0, and firm never pays b).

• This continuation following a defection is an eqm.

• Contract is self-enforcing if firm is willing to pay the bonus when y = 1.

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In this model, A’s incentives for effort are provided by the short-term, implicit contract; firm is

motivated to honor the implicit contract by concern with present value of the ongoing relationship.

Kreps, “An Economic Theory of Corporate Culture”, 1990 (see also Cremer, QJE, 1986)

— observes that “firm” may have an incentive to honor the implicit contract even if indivs.

making decisions about paying the bonus have finite employment horizons

— if these indivs. own shares in the firm and can sell their shares to others (e.g. law partner-

ships)

— reneging today reduces value of shares

— workers, too, can have finite horizons, as long as each worker learns whether the firm ever

reneged in the past

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b. Simple model of “pure” but distortionary explicit incentives (BGM (94))

— A’s privately-observed effort stochastically determines a performance measure p, which is

objectively measurable, so can be the basis of an explicit contract.

— But p ∈ {0, 1} is an imperfect proxy for A’s contribution to firm value:P (p = 1 | e) = ue, where u is ex ante random with E(u) = 1 but is observed by A

before choosing e at cost c(e) = γe2.

— A “pure” explicit contract pays, in addition to base salary s, an explicit bonus β iff p = 1.

− A’s effort fluctuates with u (e = uβ/2γ), even though first-best effort (1/2γ) is indep.

of u.

− Setting β = 1 implies A’s expected effort is first-best, but fluctuations in e per se reduceA’s expected utility (since c(e) is strictly convex), so required salary s increases.

− Optimal β∗ = 11+var(u) < 1 and ↓ in var(u)

− firm trades off strength of incentives against magnitude of (inefficient) fluctuations ineffort

− the more distortionary is the explicit performance measure (larger var(u)), thesmaller are the optimal explicit incentives

− firm’s per-period profit ≡ V (β∗) ↓ in var(u)

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c. Interaction between implicit incentives (relational contracts) and explicit in-

centives (formal contracts) (BGM (94))

A contract with implicit and explicit components: base salary s; implicit bonus b iff y = 1; explicit

bonus β iff p = 1.

Question: Are implicit and explicit incentives substitutes or complements in P ’s incentive design

problem? i.e. do optimal levels of b and β vary with var(u) in opposite directions or the same

direction?

Again, focus on cooperation supported by trigger strategies.

If A expects firm to honor the implicit component, A chooses c0(e) = b + uβ ⇒ e = b+uβ2γ

But now, if firm reneges, parties revert to

— a pure explicit contract if V (β∗) > 0

— no further interaction if V (β∗) ≤ 0

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Formally similiar interactions between relational contracts (informal arrangements) and formal con-

tracts have been examined in other contexts:

• vertical integration, by affecting (fallback) payoffs from spot transactions, can affect performanceof relational contracts (Baker, Gibbons, and Murphy, QJE, 2002)

• publicly-provided social insurance can affect performance of informal family insurance arrange-ments (Di Tella and MacCulloch, EJ, 2002)

• public insurance provided through redistributive taxation may crowd out private insurancearrangements that are subject to limited enforcement (Krueger and Perri, 2010)

• “globalization”, by expanding (fallback) market alterntives, can potentially impede risk-sharingin long-term employment relationships (McLaren and Newman, 2002; Spagnolo, 2002)

• for experimental evidence on interaction between informal and formal arrangements, see Laz-zarini, Miller, and Zenger, JLEO, 2004.

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2. Learning about agent’s intrinsic characteristics

a) Signaling

b) Signal-jamming

In both a) and b), P learns from A’s current performance about A’s intrinsic characteristics, which

are relevant to A’s future performance; A has implicit incentives to change current perf. to influence

P ’s beliefs about A’s type and hence P ’s future decisions.

This mechanism operates even in finite-horizon settings, e.g. 2 periods.

(How do incentives change as near end of horizon? Depends upon whether A can “sell” his

reputation and on whether changes in ownership are observable by clients−see Tadelis, JPE, 2002;Mailath and Samuelson, REStud, 2001; Hakenes and Peitz, IER, 2007).

a) Signaling (hidden information)

Ex.: Spence (1973) model of education as a signal in labor market

A’s ability - privately observed by A

A’s effort (e.g. educational credentials, effort at self-promotion) - public signal

market pays wages based on estimate of ability

If MC of effort lower for higher-ability workers, workers would have incentive to use effort to

signal higher ability and hence generate higher wage offers.

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b) Signal-jamming (hidden action)

Ex.: Holmstrom (1999) model of managerial career concernsA’s ability − observed by no one

A’s effort − privately-observed by A

A’s output − depends on ability and effort

− public signal

Labor market pays wages based on estimate of ability

Incentives for effort derive from possib. of influencing mkt’s beliefs about ability, since mkt

can’t distinguish btw. effects of ability and effort on output.

Remark: There can exist models intermediate btw. signaling and signal-jamming.

• For ex., with hidden information, A might take an unobservable action (depending on his type)that generates a noisy signal. Could call this “noisy signaling”.

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Other exs. of implicit incentives which can be modeled as signaling or signal-

jamming:

− ratchet effect in regulation (firm’s type is its intrinisic efficiency)

— e.g. Laffont and Tirole (1988), Meyer and Vickers (1997)

− incentives for incumbent politicians seeking re-election (politican’s type can be ability or pref-erences)

— e.g. Coate and Morris (1995)

− incentives for influence activities in firms (employee’s type can be his own quality or quality ofhis project, division, etc.)

— e.g. Meyer, Milgrom, and Roberts (1992)

− incentives for firms to provide high-quality products (firm’s type is its ability to provide highquality)

— e.g. Tadelis (2002), Mailath and Samuelson (2001)

− incentives for experts to provide good advice (expert’s type can be quality of his informationor how closely his preferences are aligned with decision maker’s)

— e.g. Avery and Meyer (2009), Scharfstein and Stein (1990), Ottaviani and Sorensen (2006),

Prat (2005)

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