incentives ii. ideas from behavioral economics for ... - incentivesiiho.p… · 1. a quick review...

1. A Quick Review from Incentives I2. Behavioral Approaches to Agency and Motivation

3. Some Models of Intrinsic Motivation

Incentives II. Ideas from Behavioral Economicsfor Understanding Incentives in Organizations

Lowell J. Taylor

CLSRN Summer SchoolJune 2013

Lowell J. Taylor Incentives II



Introduction

� This lecture considers applications from behavioral economicsthat are working their way into labor economics.

� The focus—almost exclusively—is on behavioral aspects ofagency.

� In most cases, the contribution from behavioral economicscomes in the form of nonstandard preferences (e.g., socialpreferences).




1. A Quick Review from Incentives I

2. Behavioral Approaches to Agency and Motivation2.1. Pay Status: Incentives and Inequality Aversion2.2. Effort Norms2.3. Identity

3. Some Models of Intrinsic Motivation3.1. Pay and Selection on Dedication3.2. Social Preferences and Conformism3.3. Whom Do You Want to Impress?




In the first lecture, we looked at three basic models of imperfect orincomplete information:

� Moral Hazard. The uninformed party has imperfectinformation about actions taken by a second party, and theuninformed party moves first.

� Adverse Selection. The uniformed party has incompleteinformation about the characteristics or traits of the informedparty. The uniformed party moves first.

� Signaling. The uniformed party has incomplete informationabout the informed party, but the informed party moves first.




Analysis of moral hazard leads to observations about

� incentives regarding individual pay;

� team-based incentives (which can have important effects onhierarchical structures in firm); and

� key consequences for labor markets generally, as in the case ofefficiency wages, which can result in equilibriumunemployment or dual labor markets.

Examples of signaling include

� the worker signaling the firm, as in Spence’s model, and

� the firm signaling workers, as in the Ritter-Taylor model.

An example of adverse selection in the labor market is

� Akerlof’s rat race model.




2.1. Pay Status: Incentives and Inequality Aversion2.2. Effort Norms2.3. Identity

Behavioral Approaches to Agency and Motivation

We’ll be using the same basic tools in today’s lectures. But wealso introduce of elements intended to shore up the psychologicalfoundation of agency models.

As Camerer and Loewenstein (2004) suggest,

Theories in behavioral economics . . . strive forgenerality—e.g., by adding only one or two parameters tostandard models. Particular parameter values then oftenreduce the behavioral model to the standard one, and thebehavioral model can be pitted against the standardmodel by estimating parameter values. Once parametervalues are pinned down, the behavioral model can beapplied just as widely as the standard one





Pay Status: Incentives and Inequality Aversion

When it comes to material well-being, people dislike being low onthe totem pole (Frank, 1984, 1985).

� This idea suggests including “asymmetric inequality aversion”into utility functions.

� Fehr and Schmidt (1999) is an important paper thatinvestigates the consequences of a particular form of “socialpreference”—inequality aversion.

� Fehr and Schmidt introduce this idea in a behaviorallystripped-down way; for instance, intentionality is absent fromthis model.





Fehr-Schmit: Let x1, x2, . . . xn be monetary payoffs to n individuals.

� The utility of player i depends on everyone’s payoff;ui (x1, . . . , xn) is

xi − αi

∑j �=i

max[xj − xi , 0]

n − 1− βi

∑j �=i

max[xi − xj , 0]

n − 1,

where βi ≤ αi and 0 ≤ βi .

� With two players, utility for player 1 is just

u1(x1, x2) = x1 − α1max[x2 − x1, 0]− β1max[x1 − x2, 0].





A nice application is to an ultimatum game.

� A proposer offers to divide a fixed amount of money betweenhimself and a responder.

� The responder can accept or reject this offer.

� If the offer is accepted, money is divided accordingly.

� If the offer is rejected, however, neither party gets any money.

Solutions:

� With conventional preferences, the solution is for the proposerto propose to keeps all (or nearly all) of the money. Theresponder then accepts.

� The solution is different with Fehr-Schmidt preferences. If theproposer’s offer generates too much inequality, the responderrationally rejects. Knowing this, the proposer makes areasonably generous offer.





Fehr and Schmidt’s Proposition 1:

� Responders reject offers if they are “too unfair,” so in turnproposers make offers in which the share offered, s, is closerto 1

2 than would be predicted with conventional preferences.

Fehr and Schmidt’s Proposition 2:

� Now consider a game in which there are several proposers,and the responder gets to choose from among them.

� In this case, even with the Fehr-Schmidt preferences, thesubgame equilibrium entails at least two proposers offerings = 1.

The point is that people may care about inequality, but in a settingwhere competition matters, there’s nothing they can do about it.Equilibrium is the same with inequality aversion as with normalpreferences.





We can try Fehr-Schmidt preferences in examples from Lecture I.

Example 1. The Tournament Model

� Instead of having agent utility u = w − e, try

utility =

{w0 + b − δW b − e for “winners,” andw0 − δLb − e for “losers.”

δW ≥ 0 reflects empathy winners feel for losers; δL > δW

indicates that losers suffer a larger utility loss due toinequality aversion.

� It is easy to show that the firm reduces the bonus awarded tothe winner, and settles for a second-best effort level, e∗∗ < e∗.

� Inequality aversion leads the firm to compromise—loweringincentive pay, which reduces effort elicited.

� Should P be set near 0 (so there are few losers)? Are theresteps firms can take to reduce the corrosive effects ofinequality? Is it a good idea to dismiss the losers?





Example 2. “Rent Sharing”

� If the agent compares her income to the principal’s income,the result might be “rent sharing.”

� Reducing wages to the level of an employee’s outside optioncan be self-defeating in this context because it risks that theagent will become disgruntled and take steps to “even thescore.”





Does any of this matter in real-world markets, or does competitiondrive out the role of inequality aversion?

Fehr and Schmidt (1999) argue:

. . . competition renders fairness considerations irrelevantif and only if none of the competing players can punishthe monopolist by destroying some of the surplus andenforcing a more equitable outcome. This suggests thatfairness plays a smaller role in most markets for goodsthan in labor markets. This follows from the fact that, inaddition to the rejection of low wage offers, workers havesome discretion over their work effort. By varying theireffort, they can exert a direct impact on the relativematerial payoff of the employer.





The Fehr-Schmidt conjecture has been examined in manyexperiments; see Fischbacher, Fong and Fehr (2009), and referencetherein. In their experiments,

� increasing proposer competition in the Ultimatum Game, byadding extra proposers, causes an increase in mean acceptedoffers, while

� increasing responder competition reduces mean acceptedoffers.





As for labor markets more generally:

� The idea that workers exact retribution upon employers whentreated unfairly is supported by Bewley’s (1999) extensivequalitative interviews.

� Mas (2006) finds that when New Jersey police lose in finaloffer arbitration—so the wage they receive is lower than therequested wage—arrest rates and average sentence lengthsdecline, while crime reports rise. This is consistent with theidea that workers are less inclined to provide effort when thewage falls below a salient reference.

� Krueger and Mas (2004) report that a contentious strike andthe hiring of replacement workers in a Bridgestone/Firestoneplant contributed to the production of defective tires.





� Mas (2008) finds Caterpillar plants that underwent contractdisputes experienced reduced workmanship and reducedproduct quality.

� Nagin, Rebitzer, Sanders, and Taylor (2002) look at anon-union environment. We manipulated monitoring levels atcall centers. We had (i) a direct measure of malfeasance byindividual employees and (ii) measures of employeeperceptions about the employer. When given the opportunity,malfeasance was most prevalent among workers who hadexpressed feelings that the employer treated them unfairly, didnot care about them, and provided a bad place to work.





Effort Norms

Akerlof’s (1982) model of “gift exchange” relies on very differentsociological and psychological mechanisms than the standardagency approach.

� Instead of calculating costs and benefits of working harder,employees in Akerlof’s model are motivated by normsgoverning behavior in the exchange of gifts.

� Decent people, so the reasoning might go, return kindnesswith kindness and so, wishing to preserve the self image ofdecency, an employee responds to a generous wage byreturning the favor in the form of high effort.

� In a simple example, Akerlof shows that the labor marketconsequence can be unemployment.





A nice way to model fairness is found in an important work byRabin (1993, 2002, etc.).

Rabin takes an intention-based approach. People have socialpreferences in which they have positive feelings about those whomthey think are nice. The key assumptions are:

� People are willing to make material sacrifices to help otherswho are being kind.

� People are willing to punish others who are unkind.

� There are limits to the previous two motivations.

An important feature of the framework is that payoffs depend onactions (as usual) and on beliefs. Making attributions aboutintentions requires the use of a norm.





Card, Della Vigna, and Malmendier (2011) give a nice discussionabout experimental evidence for understanding gift exchange.

� The start point is Fehr, Kirchsteiger and Riedl (1993), inwhich “workers” respond to generous offers by “firms” byexerting more “effort,” as predicted by gift exchange models.

� Of course lab experiments may not pertain in the “real world.”Gneezy and List (2006) design a field experiment to see if labresults carry over—finding that higher pay leads to greatereffort for a while (3 hours), but the effect is short lived.

� Card, Della Vigna and Malmendier note two models thatmight provide explanations: inequality aversion (as in Fehr andSchmidt, 1999) or an intention-based approach (like Rabin,2002). The Fehr-Kirchsteiger-Riedl experiment is consistentwith either approach, but the Gneezy-List field experimentcannot be explained by inequality aversion. Instead, theremust be some form of social preferences such as reciprocity.





There is a growing literature on work norms. Here are someexamples:

� Ichino and Maggi’s (2000) study of workers in differentbranches of a large Italian bank finds “peer effects.”

� Falk and Ichino (2006) have a experiment that shows apositive impact on output due to “peer effects.”

� In a remarkable study of cashiers at a national supermarketchain, Mas and Moretti (2008) find that substituting a workerwith below average productivity for a worker with aboveaverage productivity is associated with a 1 percent increase inthe effort of other workers on the same shift.





Identity

Akerlof and Kranton (2005) have interesting recent work onidentity.

The term identity is used to describe a person’s socialcategory—a person is a man or a woman, a black or awhite, a manager or a worker. The term identity is alsoused to describe a person’s self-image. It captures howpeople feel about themselves, as well as how those feelingdepend upon their actions. In a model of utility, then, aperson’s identity describes gains and losses in utility frombehavior that conforms or departs from the norms forparticular social categories in particular situations. . . . Inour conception, utility functions can change, becausenorms of appropriate and inappropriate behavior differacross space and time.





Gender Identity

Can identity models generate falsifiable hypotheses? A templatemight be found in recent work on gender.

� Women are less likely than men to initiate negotiation (Small,Gelfand, Babcock, and Bettman, 2007).

� Women do less well than men when negotiating forthemselves, but better when negotiating for others (Bowles,Babcock, and McGinn, 2006). Women avoid self promotion.

� Women fare less well than men in tournament style incentives,and tend to shy away from them (Gneezy, Niederle, andRustichini, 2003, and Niederle and Vesterlund, 2007).

� Gender identity, in short, matters. But why? Do women preferto avoid self-advocacy or do they fear a backlash if theyviolate feminine norms of kindness and gentility? See Bowles,Babcock, and Lai (2006) on backlash.





Here’s a study currently being conducted by Linda Babcock.

� The issue is: Would you rather negotiate or listen toextremely unpleasant sounds?

The potential negotiations are about:

1. Payment for a formal dinner party at your dorm.

2. Details—linens, glasses, etc.—in a formal dinner party at yourdorm.





Your choice is to negotiate over this ...





or listen to this:





Figure: From Bear, J. and Linda Babcock (2012), “Gender Differences inthe Decisions to Negotiate: The Moderating Role of Negotiation Topic.”




3.1. Pay and Selection on Dedication3.2. Social Preferences and Conformism3.3. Whom Do You Want to Impress?

Some Models of Intrinsic Motivation

Our last part of our lecture looks at intrinsic motives—includingthe possibility that extrinsic incentives can undermine intrinsicmotives.

� Many psychologists believe this idea. See, e.g., the extensivework of Deci.

� Economists are familiar with work on this topic by Frey, Fehr,Falk and others.

� We’ll thus ask here what happens in be models in which firmshave to worry about managing intrinsic motivation.





Selection on Dedication

Our first example is an adverse selection model in which firms hireworkers who have a “calling” or “vocation.”

� There may be many examples of this sort of dedication: themilitary, religious ministry, policy advocacy, nursing, earlychildhood education, public-interest law, etc.

� The “calling” in this case is a potentially important form ofintrinsic motivation.





Heyes (2005) looks at the market for nurses: There are L qualifiednurses, each of whom falls into two categories:

� Proportion 1− π view nursing as simply a job. Utility is w .Value produced is qL.

� Proportion π view work as a “vocation.” Utility is w + m(where m is positive). Value produced is qH > qL.

Nurses of both types have a reservation wage r , drawn from a logconcave p.d.f., f (r).

� So at wage w , the quantity of nursing labor supplied is

L(w) = [πF (w + m) + (1− π)F (w)]L,

� and the average quality is of nursing care is

q(w) = θqH + (1− θ)qL,

where θ is the proportion for whom nursing is a vocation,

θ = πF (w + m)/[πF (w + m) + (1− π)F (w)].









Heyes’ insight is that average quality is declining in the wage;

� the derivative of θ with respect to w has the same sign asF (w+m)f (w+m) − F (w)

f (w) , which is negative (given log concavity).

In Taylor (2007), I find that

� a monopsonist that maximizes surplus for the organizationsets the wage lower than the socially efficient level, but

� in a perfectly competitive market the wage is inefficiently high.

A number of papers explore similar issues:

� Delfgaauw and Dur (2007) have a wage posting model inwhich a monopsonist faces the tension discussed above: highwages increase the probability of filling a vacancy, but lowerthe expected motivation level of applicants.

� Besley and Ghatak (2005) and Delfgaauw and Dur (2008)study public sector employment when some agents have a“public service motivation.”





Social Preferences and Conformism

Sliwka (2007) has a “social preference framework” model withthree types of agents:

� Steadfast agents who are “strictly selfish,”

� steadfast agents who are “fair” (care about others’well-being), and

� conformists whose inclination is to behave like the majority!

In particular,

utility =

{w(e)− e2

2 for a steadfast selfish agent, and

w(e)− e2

2 + μπ for a steadfast fair agent,

where μ reflects a fair agent’s level of identification with theprincipal’s objective (with 0 < μ < 1).





The principal posts a policy w(e) = w0 + βe; effort is assumed tobe observable ex post. The solution works like this:

� An agent’s best response depends on his preferences overeffort, and if he is a conformist, also on his perception of thepreferences of other workers.

� If almost all agents are “selfish,” the principal sets w0 quitelow and β quite high.

� If almost all agents are “fair,” lower-powered incentives areused—β is lower.

� Remarkably, a principal who understands that his workforce iscomprised predominantly of “fair agents” can set w0 high andβ low to credibly signal “conformists” to play “fair.”

Sliwka calls this mechanism “trust as a signal of a social norm.”





There is a lot of evidence on norms—the key behavioralunderpinning of the Sliwka model.

� See for examples, Fisman and Miguel (2007), Ichino andMaggi (2000), Mas and Moretti (2009), and Bandiera,Barankay, and Rasul (2005, 2009).

Fischer and Huddart (2008) discuss the role of endogenous socialnorms on organizational design.





Impressing the Principal

Ellingsen and Johannesson’s (2008) model, like Sliwka’s, relies onsocial preferences. But the behavioral mechanisms are quitedifferent. The model has three components:

� Agents and principals hold social preferences; they care abouttheir own wellbeing and the wellbeing of others.

� There is unobserved heterogeneity in the extent to whichagents and principals value others’ wellbeing (i.e., the extentto which they are pro-social).

� Agents and principals are motivated by social esteem: Theagent cares about what the principal thinks about her, andthe principal cares about what the agent thinks of him. Bothwant to be thought of as pro-social by the other.





Ellingsen and Johannesson’s game proceeds as follows:

� The principal takes an action—e.g., a wage offer, or a decisionabout how much discretion to allow the agent in her work.

� Then the agent takes an action that affects both her materialwellbeing and the principal’s wellbeing.

There is a set of parameters on preferences and the distribution oftypes such that a separating equilibrium emerges:

� A pro-social principal can credible signal that he is pro-socialby being generous, and,

� if she is sufficiently pro-social, the agent responds with anaction that benefits the principal.

The driving behavioral force? A pro-social agent wishes to behighly regarded by a pro-social principal. Having learned that theprincipal is pro-social, the agent takes a pro-social action as ameans of securing the knowledge that the principal believes her tobe pro-social.





The Ellingsen-Johannesson approach can rationalize the “trustgame” of McCabe, Rigdon, and Smith (2003): When the principalcan trust, the agent often rewards.

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Impressing Others

Benabou and Tirole’s (2006) model of “virtue”: Agents havevarying levels of kindness (concern for others) and temperance(moderation in materialistic pursuit).

Take a case where effort e can be 0 or 1. Utility comes from foursources:

1. The agent is other-regarding, earning utility vee whenproviding effort e. Individuals with high ve are kind.

2. He earns a material reward in the form of a bonus of b ≥ 0,giving utility vmbe. Individuals with low vm are temperate.

3. He faces an effort cost of ce.

4. He can gain from the reputation-enhancing effect of choices.Agents want to be known as temperate and kind.





Central to the Benabou-Tirole model are two assumptions, whichdrive development of reputation:

1. Agents differ in kindness and temperance: An individual’s setof preference parameters—his “identity” (ve , vm)—is drawnfrom a known distribution.

2. Reputation is taken to be other’s views of one’s identity:

R(e, b) = μeE [ve |e, b]− μwE [vm|e, b],

where μe and μw are weights that reflect the degree ofimage-consciousness (taken to be common knowledgeconstants here).

To summarize,

utility =

{ve + vmb − c + R(1, b) if e = 1 andR(0, b) if e = 0.





Recall the agent must make a 0/1 effort decision.� Effort is 1 if

ve + vmb + [R(1, b)− R(0, b)] > c .

� The terms on the left-hand side of this equation are,respectively, the agent’s intrinsic, extrinsic, and reputationalmotivations.

� Effort is provided when the sum of these motivations exceedsthe cost of providing effort.

What makes matters interesting is that reputation depends on thelevel of the bonus b chosen by the principal. To see this, notice:

� If b = 0, motivation is strictly intrinsic and reputational; effortis provided only if his “concern for others” exceeds ve :

ve ≡ c − [R(1, 0)− R(0, 0)].

� b > 0 must reduce reputational value. In the Figure (nextslide), identity types in area B reduce effort.









Highly pro-social identity types lie to the right of the vertical “NoBonus” line. What happens when b > 0?

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Impressing One’s Own Self

Benabou and Tirole (2006) have an “identity” interpretation oftheir model. The reasoning goes as follows:

� I want to view myself as temperate.

� I want to view myself as kind.

� This can lead to “crowding out” of intrinsic motivation: “Ifyou offer me high pay, you deprive me of the opportunity toreinforce my identity.”





Evidence on Crowding Out

� There is some evidence of crowding out gathered byeconomists, in work by Fehr, Falk, Frey, Gneezy, Rustichini,and others.

� There is a great deal of work in psychology. It is interesting tothink about how these findings might apply in labor marketsettings.





A Concluding Puzzle

� Most economists agree that well designed extrinsic rewardsare crucial to the resolution of fundamental and ubiquitousagency problems.

� It is, as we have seen, possible to construct models whereextrinsic rewards undermine intrinsic motives, but theseappear largely as elaborations and qualifications of thefundamental message.

� Matters are quite different in psychology, which hasaccumulated a vast amount of evidence that extrinsic rewardsundermine intrinsic motives.

� What explains the difference?





Final Remarks

Rebitzer and Taylor (2011) suggest that many relevant ideasworking their way from behavioral economics into agency theoryand labor market analysis. Examples include:

� why inequality aversion sometimes matters,� the importance of effort norms and professional norms (and

their internal and external drivers), and� the role of identity.

Promising areas for research might include:

� the behavioral foundations of “conflict of interest,” e.g., inthe health and financial sectors,

� better structure in the study of identity,� implications of behavioral ideas for labor policy, and� further work on the behavioral foundations of intrinsic

motivation.





Many of the ideas used in these slides are drawn from:

Rebitzer, James and Lowell J. Taylor (2011), “Extrinsic Rewards and Intrinsic Motives:Standard and Behavioral Approaches to Agency and Labor Markets,” in OrleyAshenfelter and David Card, editors, Handbook of Labor Economics, vol. 5.Amsterdam: North Holland.

Also, most of the references to other research can be found there.


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