personnel economics 10 1 chapter 12: teams and reward systems why do firms exist in the first place?...

1Personnel Economics 10

Chapter 12: Teams and reward systems

• Why do firms exist in the first place?

• When should teams be used?

• How does peer pressure operate in a team?

• How should a team look like, which individuals should form a team?


Team compensation

When/why would a company use team compensation?

• Individual effort difficult to measure• Motivate cooperation among workers

• Congruence of type of work and type of compensation:If teamwork is important, use team-related pay

Ex: Basketball


The free-rider problem

• When individuals work in teams, it is difficult to observe the output of individuals possibility: compensation by team

• But: individuals can hide behind others (free ride)


Public goods problem

Everybody in team contributes to output, but each member gets only a share of the reward for own action

– Example: sharing the bill at a restaurant

• Ten people go to the restaurant and share the bill. Do you order the cheap (6 €) or expensive menue (12 €)? Why? What is the result?


Everyday economics

Lesson for staying slim?

• Go out in small groups and

• Never share the bill!

• Problem is: why are the French and Italian so slim?



• There are two individuals i and j with 10 € each. The money can be invested into a public good (x) or be kept for oneself.

The payoff of individual i is given by:

(10 – xi) + 0.6 (xi + xj)

• How much would you put into the public good?

• Assume there is only the choice of putting all or nothing into the public good. How does the payoff-matrix look like? What is the result?



Ten people are one team. Group gets a bonus of € 100 if project is finished one day earlier. Bonus will be divided by number of group members.

– If you worked overtime one evening - instead of going out with your friends - you could speed up the project enough, so that it would be finished earlier. Will you stay late?


Result of public goods problem

• One-shot prisoner‘s dilemma– Efficient solution would be that everybody contributes

everything to the public good

– Nash-solution will be that nobody contributes anything

Remember from Managerial Economics or IO:

• In finitely repeated games: No cooperation

• Only infinite repetition of game or uncertainty about the end of game leads to cooperation

• Else: non-economic reasons like trust, norms, etc... See later


WHEN TO USE TEAMS


When to use teams?

• Benefits: – Output of two (or more) workers together is more than the sum of

the outputs of each worker „Use teams if the whole is bigger than sum of its parts“

– Large complementarities what one worker does and what another does

• Deadlines to meet • Physical complementarities (lifting an object)• Share information and coordinate better

• Costs: productivity loss through free-riding – affected by size of team


When to use teams?

• Benefits: Output of two (or more) workers together is more than the sum of the outputs of each worker „Use teams if the whole is bigger than sum of its parts“

Example: 2 projects, each can be done by one worker in 4 weeks or two workers in 2 weeks.

– Project A gives profit of € 10.000 if finished in 2 weeks, else € 5.000.

– Project B has to be finished in 4 weeks, gives profit of € 15.000.


Other direct benefits of team work

• Specialization– Allows to do job more efficiently (Adam Smith)

• Knowledge transfer (if specialization is not too great)

– 1. Individuals possess non-overlapping (idiosyncratic) information sets

– 2. Idiosyncratic information possessed by one person is valuable to others

team should consist of people who have something to share• Ex: accountant and auto-mechanic• Ex: research team: theory, econometrics and data access


Information Frisch has

Information Engel has


Team size

• Large teams create communication problems• Small teams do not have enough info to share

• Incentive intensity determined by team size: – own benefit = return to own effort/group size

– The larger the team, the more severe is the free-rider problem

– Peer monitoring more effective in smaller teams• Easier to observe effort in small teams („It wasn‘t me!“)• One member‘s shirking has bigger effect on every other

worker, so incentive to punish her is bigger


Incentives in teams

1. Team bonus

2. Profit sharing

3. Stocks and options

4. Implicit rewards

5. Norms


1. Team bonus

Bonus for finished project, split among members

– Small groups– Well-defined project/output– Short duration, so that team remains intact

• Ex: construction project

• Ex: football team


2. Profit sharing

Reward based on company profits, typically split in proportion to worker‘s base salary. Share = (worker j‘s base annual salary)/total wage bill

• Team = whole firm• Why would somebody set group size so high?

– Free-rider problem enormous!– Workers have their human capital already tied up in one firm, they

should diversify their financial capital to reduce risk (ex. ENRON)• Important argument against firm-specific pension fund

• Profit sharing is risk sharing which transfers some of the risk from stockholder to workers (should be compensated)


Profit sharing in a more positive light

• Profit sharing can be motivating– Symbolic action, can help to internalize firm goals „We

are one!“

– Intrinsic motivation more important if explicit incentives are difficult to install

– Create a „firm spirit“ of high-commitment as incentive mechanism

– Sometimes „firm spirit“ particularly valuable (trademark, customer contacts, quality of product important, etc.)


3. Stocks and options

Usually for high-level managers

– Cooperation is very important– Impact on firm is big– Makes them care about own and other peoples‘

output


Stocks and options

• Stock: ownership claim on a corporation

• Call option: the right to buy stock to the exercise or strike price K in future. – „In the money“: Market price (X) of stock exceeds

strike price (K)– „Out of the money“: X < K: Option is not exercised– Employee profits from the call option if it is „in the

money“, i.e. the strike price is lower than the market price at pre-specified date.

• Stock of the firm is an option with strike price=0.


Value of an option contract

• Assume an option has a 50 % chance to be worth € 90 or € 110 each.

• Current stock price is € 100

• Assume: you want to give the manager a reward with an expected value of €100.

Strike price Value of one option Number of options required

0 100 1

80 20 5

100 5 20

108 1 100



• The higher the exercise price, the larger the number of options that must be granted to produce a given expected value.

• Which combination of number/exercise price should firm choose?

– Consider: value of an option increases as value of firm rises.



• Example: Action of worker (i. .e. high effort of the worker) increases value of firm by € 1 mio. There are 1 million shares, so the action raises value of every share by € 1.

Strike price

Number of options required

Value of one option (no action)

Value of one option (after action)

Net value of action to manager

0 1 100 101 1

80 5 20 21 5

100 20 5 5.5 10

108 100 1 1.5 50



• Incentive effects differ for options with different strike prices:– Large number of options with higher strike

price creates higher incentive for manager• Leverage effect

• Managers have incentive to choose more risky projects


Why have options become popular?

• Have been introduced in period of rising stock prices

• Tax treatment in some countries

• Good incentive effects for managers

• Possibility of spreading the risk for the firm (costs relatively little in case of success and nothing in case of failure)


4. Implicit rewards

• Firms usually pay higher wages when they make higher profits (to all workers)– Bargaining power of workers is higher– Firm does not want to lose workers

• In most firms, these implicit bonuses account for a bigger share of a firm‘s wage bill than explicit bonuses.


5. Can norms help to alleviate group free-riding ?

• Norms are practices a firm engages in or a set of beliefs held in a firm, part of a firm‘s culture

• Monitored by peer pressure: e.g. criticism, ostracism (Ächtung)

– Peers bear ongoing enforcement costs for the norm, punish violators with lower (sometimes also higher) effort levels

– Norms break down if pressure lets up and enforcement lags– Workers have a hard time to empathize with nameless,

faceless shareholders, but more easily with co-workers– Creating norms leads to empathy, loyalty and latent guilt


Group composition

• People are different, differently suited for different tasks• People possess different pieces of information

– Takes time to convey information, but maybe diminishing returns of doing so

Rotating of group members

• Con: „Person-specific“ HC, takes time to get to know each other and build up trust and communicaton (e.g. people from different disciplines!)

personnel economics 10 1 chapter 12: teams and reward systems why do firms exist in the first place?...

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personnel economics

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managerial economics

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public good x

everyday economics lesson