CHAPTER 6
Market Failure and Incentive Issues Inside the
Firm
CHAPTER SUMMARY AND TEACHING OBJECTIVES
The important message in this chapter is that compensation is not independent of a firm’s
performance—of its economic profit.
1. Compensation of employees is not a straightforward matter. No only is productivity difficult to
2. Students must understand why incentives matter and what incentives drive what behaviors.
Moreover, they must realize that compensation policies cannot be segregated from performance
measures of the firm. In addition, it is important that they realize that not every firm can
compensate in the same way—organizational structures, markets, and transactions vary and so
must compensation structures.
IMPORTANT TERMS
Efficiency wage a wage that is higher than the existing market wage in order to attract the highest
quality employee and to ensure employees want to remain with the firm
backloaded compensation a compensation scheme whereby employees are paid less than their value
to the firm in the early years of employment and more than their value in later years
TOPICS AND TEACHING SUGGESTIONS
1. Market Failures Inside the Firm
It is often difficult to measure the contribution of an employee. This is especially true if the
contribution of individual is difficult to untangle from the participation of other employees. This is
particularly the case when teams are used. Some team members may free ride on the efforts of
others.
A firm has been called a nexus of contracts—a series of principal-agent relationships. Students
2. Compensation Arrangements
It is important that students understand that employees are paid is various ways and that individual
behavior is related to the incentive in the alternative pay schemes. One goal for all of them is to
connect the self-interest of the employee to the success of the overall enterprise. In some sense,
the easier it is to recognize the productivity or contribution of an employee, the easier it becomes
to design a pay scheme that will affect that productivity.
Teaching Strategy: If you use teams in class, ask if your students like the use of teams. Do some
free ride? What happens if team members can evaluate other team members? Is there less
freeriding?
ANSWERS TO EXERCISES
1. Personal injury lawyers may be paid a contingency fee equal to a percentage of the amount
awarded. The lawyer receives payment only if his or her client wins the case and is awarded a sum
of money. Lawyers in other types of cases are often paid on an hourly basis. Use the principal-
agent relationship to assess the merits and drawbacks of each type of fee arrangement from the
client’s (i.e., the principal’s) perspective. Be sure to discuss incentive effects.
Agency theory recognizes lawyers as the agents and the clients as the principals. The contingency fee
2. Suppose that an employee has two tasks to perform, assembling machinery and evaluating quality.
Suppose that the supervisor can only observe how many machines the worker has assembled.
Under what conditions should the principal closely tie pay to performance on the first task?
3. It is said that the current generation of workers will have a very small probability of being
employed by the same firm throughout their worklife. In previous generations it was common for
people to have just one employer. Is a more rapid turnover among employees beneficial to the
firm? To the employee? Explain
It depends on the business the firm is in. A firm that needs new knowledge or human capital that
cannot be created in-house must seek new employees. Such firms create situations of rapid
4. Many firms that use operators to assist customers evaluate the operators on the basis of how many
customers they service. Explain the results of such an evaluation system. What would you do
differently? Consider the benefits and costs of any change you recommend.
5. A recent study found that workers who were laid off generally received lower wages once they
found new jobs. The study noted that white-collar workers suffered relatively large declines
compared to blue collar workers. How would you explain this development?
6. The same study of workers and their lower paying jobs mentioned in question 5 found that
workers who had been with a firm a longer period of time suffered larger declines than those who
had been with a firm for a relatively short period of time. How would you explain this
development?
7. Prior to about 1990, several firms instituted explicit policies never to lay off employees, that is, to
create lifetime employment. What are the costs and benefits of such a policy? What types of firms
might find such a policy beneficial?
8. What type of compensation policy would you expect to observe in an industry with rapidly
changing technology? Explain.
9. What type of compensation policy would you expect to observe in an industry where technology
changes are few and far between?
10. When Ben and Jerry decided to step down as managers of their own company, they announced
that the new CEO would not earn more than 10 times the lowest paid employee. What do you
think was the result of their policy?
11. The probability of a worker being fired from or quitting a particular job in any unit of time is
represented by the following function.
12. An investment has returns of zero with probability one half, $3,000 with probability one third and
$6,000 with probability one sixth. What is the expected value of the return?
13. If the investment described in exercise 12 is an individual’s possible weekly compensation and the
individual has no control over the outcome, what effort will the risk-averse individual put in?
What about the risk-seeking individual?
It seems that the amount of effort has no role in the expected value. Thus, a risk-averse individual
14. In exercise 13, if the employee was risk averse, what compensation scheme would elicit the
greatest effort?
15. What is market failure? Explain how externalities, public goods, and asymmetric information are
all problems with private property.
Market failure is when a market format does not produce the socially optimal solution. This is
16. Explain why you tend to find more shirking, more corruption, and more inefficiency in large firms
than you do in small firms. Explain why you tend to find more shirking, more corruption, and
more inefficiency in government than you do in large firms.
Shirking, corruption, and inefficiency result if individual behavior is difficult or costly to monitor.
17. Could rent seeking on the part of the CEO influence the CEO’s compensation? Evaluate the
following argument. Pay arrangements are set by a board of directors that aims to maximize
shareholder value by designing an optimal principal-agent contract. But, the board does not
operate at arm’s length; rather, executives have power to influence their own compensation,
and they use their power to extract rents. As a result, executives are paid more than is
optimal for shareholders.
18. The oil well Maconda exploded in the Gulf of Mexico in 2010, killing 11 people and creating a
huge oil spill. BP did not own the Deepwater Horizon platform, but leased it from a company
called Transocean. In what sense is this a principal-agent problem? What incentives are created
by the problem?
In some sense, BP is the agent using the property of Transocean, the principal. There is also an
19. The oil well Maconda exploded in the Gulf of Mexico in 2010, killing 11 people and creating a
huge oil spill. BP did not own the Deepwater Horizon platform, but leased it from a company
called Transocean. Would BP have paid more attention to safety if it owned, rather than leased,
the platform? Explain
20. In an advertisement for a Professional Employment Organization it was stated “Outsourcing can
be a cost effective alternative to the expense and administrative burden of a traditional employer–
employee relationship.” Evaluate the costs and benefits of outsourcing employees. What market–
failure problems could be created or eliminated by outsourcing?
With outsourcing, a company can avoid many of the costs associated with managing the