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Principal–agent problem
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===Tournaments=== Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal labour markets (Doeringer and Piore 1971, Rosen 1982) as a solution to some of the problems outlined. Here, there is "pay-for-performance" in a looser sense over a longer time period. There is little variation in pay within grades, and pay increases come with changes in job or job title (Gibbs and Hendricks 1996). The incentive effects of this structure are dealt with in what is known as "[[tournament theory]]" (Lazear and Rosen 1981, Green and Stokey (1983), see Rosen (1986) for multi-stage tournaments in hierarchies where it is explained why CEOs are paid many times more than other workers in the firm). See the [[superstar]] article for more information on the tournament theory. Workers are motivated to supply effort by the wage increase they would earn if they win a promotion. Some of the extended tournament models predict that relatively weaker agents, be they competing in a sports tournaments (Becker and Huselid 1992, in [[NASCAR]] racing) or in the broiler chicken industry (Knoeber and Thurman 1994), would take risky actions instead of increasing their effort supply as a cheap way to improve the prospects of winning. These actions are inefficient as they increase risk taking without increasing the average effort supplied. Neilson (2007) further added to this from his studies which indicated that when two employees competed to win in a tournament they have a higher chance of bending and or breaking the rules to win. Nelson (2007) also indicated that when the larger the price (incentive) the more inclined the agent (employee in this case) is to increase their effort parameter from Neilson's studies.<ref>{{cite book |last1=Nielson |first1=Williams |title=Personal Economics |publisher=Pearson Education |location=TENNESSEE, KNOXVILLE |pages=107–118 |edition=3 }}</ref> A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers might become reluctant to help out others and might even sabotage others' effort instead of increasing their own effort (Lazear 1989, Rob and Zemsky 1997). This is supported empirically by Drago and Garvey (1997). Why then are tournaments so popular? Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker performance. Tournaments merely require rank order evaluation. Secondly, it reduces the danger of [[rent-seeking]], because bonuses paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the most qualified person. This effectively takes the factors of ambiguity away from the principal agent problem by ensuring that the agent acts in the best interest of the principal but also ensures that the quality of work done is of an optimal level. Thirdly, where prize structures are (relatively) fixed, it reduces the possibility of the firm reneging on paying wages. As Carmichael (1983) notes, a prize structure represents a degree of commitment, both to absolute and to relative wage levels. Lastly when the measurement of workers' productivity is difficult, e.g., say monitoring is costly, or when the tasks the workers have to perform for the job is varied in nature, making it hard to measure effort and/or performance, then running tournaments in a firm would encourage the workers to supply effort whereas workers would have shirked if there are no promotions. Tournaments also promote [[risk seeking]] behavior. In essence, the compensation scheme becomes more like a [[call option]] on performance (which increases in value with increased [[Volatility (finance)|volatility]] (cf. [[options pricing]]). Each of the players competing for the asymmetrically large top prize may benefit from reducing the expected value of their overall performance to the firm in order to increase their chance to have outstanding performance and win the prize. In moderation this can offset the greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of public companies the principal typically owns its stake as part of a diversified portfolio. Successful innovation is particularly dependent on employees' willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth paying for the greater chance of success through innovation elsewhere in the portfolio. If however the risks taken are systematic and cannot be diversified e.g., exposure to general housing prices, then such failures will damage the interests of principals and even the economy as a whole (cf. [[Kidder Peabody]], [[Barings]], [[Enron]], [[AIG]] to name a few). Ongoing periodic catastrophic organizational failure is directly incentivized by [[tournament]] and other [[superstar]]/winner-take-all compensation systems (Holt 1995).
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