Editing Principal–agent problem (section)

==Employment contract==
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{{POV|section|date=November 2020}}
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In the context of the employment contract, individual contracts form a major method of restructuring incentives, by connecting as closely as optimal the information available about employee performance, and the compensation for that performance. Because of differences in the quantity and quality of information available about the performance of individual employees, the ability of employees to bear risk, and the ability of employees to manipulate evaluation methods, the structural details of individual contracts vary widely, including such mechanisms as "piece rates, [share] options, discretionary bonuses, promotions, profit sharing, efficiency wages, deferred compensation, and so on."<ref>
{{cite journal
  | last = Pendergast
  | first = Canice
  | title = The Provision of Incentives in Firms
  | journal = Journal of Economic Literature
  | volume = 37
  | issue = 1
  | pages = 7–63
  | year = 1999
  | jstor = 2564725
  | doi=10.1257/jel.37.1.7| citeseerx = 10.1.1.558.6657
  }}</ref> Typically, these mechanisms are used in the context of different types of employment: salesmen often receive some or all of their remuneration as commission, production workers are usually paid an hourly wage, while office workers are typically paid monthly or semimonthly (and if paid overtime, typically at a higher rate than the hourly rate implied by the salary).{{citation needed|date=October 2018}} The way in which these mechanisms are used is different in the two parts of the economy which Doeringer and Piore called the "primary" and "secondary" sectors (see also  [[dual labour market]]).

The secondary sector is characterised by short-term employment relationships, little or no prospect of internal promotion, and the determination of wages primarily by market forces. In terms of occupations, it consists primarily of low or unskilled jobs, whether they are blue-collar (manual-labour), white-collar (e.g., filing clerks), or service jobs (e.g., waiters). These jobs are linked by the fact that they are characterized by "low skill levels, low earnings, easy entry, job impermanence, and low returns to education or experience." In a number of service jobs, such as food service, golf caddying, and valet parking jobs, workers in some countries are paid mostly or entirely with [[gratuity|tips]].

The use of tipping is a strategy on the part of the owners or managers to align the interests of the service workers with those of the owners or managers; the service workers have an incentive to provide good customer service (thus benefiting the company's business), because this makes it more likely that they will get a good tip.

The issue of tipping is sometimes discussed in connection with the principal–agent theory. "Examples of principals and agents include bosses and employees ... [and] diners and waiters." "The "principal–agent problem", as it is known in economics, crops up any time agents aren't inclined to do what principals want them to do. To sway them [(agents)], principals have to make it worth the agents' while ... [in the restaurant context,] the better the diner's experience, the bigger the waiter's tip."<ref>Paula Szuchman, Jenny Anderson. ''It's Not You, It's the Dishes (originally published as Spousonomics): How to Minimize Conflict and Maximize Happiness in Your Relationship''. Random House Digital, Inc., June 12, 2012. Page 210. Accessed on May 31, 2013</ref> "In the ... language of the economist, the tip serves as a way to reduce what is known as the classic "principal–agent" problem." According to "Videbeck, a researcher at the New Zealand Institute for the Study of Competition and Regulation[,] '[i]n theory, tipping can lead to an efficient match between workers' attitudes to service and the jobs they perform. It is a means to make people work hard. Friendly waiters will go that extra mile, earn their tip, and earn a relatively high income...[On the other hand,] if tipless wages are sufficiently low, then grumpy waiters might actually choose to leave the industry and take jobs that would better suit their personalities.'"<ref>{{cite news |title=Only the tip, but size is important |date=December 11, 2004 |work=The Age |url=http://www.theage.com.au/articles/2004/12/10/1102625528796.html |access-date=July 23, 2013 |archive-date=April 1, 2016 |archive-url=https://web.archive.org/web/20160401191710/http://www.theage.com.au/articles/2004/12/10/1102625528796.html |url-status=live }}</ref>

As a solution to the principal–agent problem, though, tipping is not perfect. In the hopes of getting a larger tip, a server, for example, may be inclined to give a customer an extra large glass of wine or a second scoop of ice cream. While these larger servings make the customer happy and increase the likelihood of the server getting a good tip, they cut into the profit margin of the restaurant. In addition, a server may dote on generous tippers while ignoring other customers, and in rare cases harangue bad tippers.

===Non-financial compensation===
Part of this variation in incentive structures and supervisory mechanisms may be attributable to variation in the level of intrinsic psychological satisfaction to be had from different types of work. Sociologists and psychologists frequently argue that individuals take a certain degree of pride in their work, and that introducing [[performance-related pay]] can destroy this "psycho-social compensation", because the exchange relation between employer and employee becomes much more narrowly economic, destroying most or all of the potential for social exchange. Evidence for this is inconclusive—Deci (1971), and Lepper, Greene and Nisbett (1973) find support for this argument; Staw (1989) suggests other interpretations of the findings.

Incentive structures as mentioned above can be provided through non-monetary recognition such as acknowledgements and compliments on an employee (agent) in place of employment. Research conducted by Crifo and Diaye (2004) <ref>{{cite web |last1=Crifo |first1=Patricia |title=INCENTIVES IN AGENCY RELATIONSHIPS: TO BE MONETARY OR NON-MONETARY? |url=https://d1wqtxts1xzle7.cloudfront.net/41461726/INCENTIVES_IN_AGENCY_RELATIONSHIPS_TO_BE20160123-17475-j6j93s.pdf?1453537375=&response-content-disposition=inline%3B+filename%3DINCENTIVES_IN_AGENCY_RELATIONSHIPS_TO_BE.pdf&Expires=1603959797&Signature=JaMU2eevkTupkP2pc-GCkii1AH-0ai63RTCR81tQuey9vJdSzOrNrabxAU7XRcYLRPczwQ4JYQhBJxdsBHjQc8LhE7I6L5kdp6Kv28eyHbXs2pzsyiTbkask8wq~NBhFgbq3YMxxPXXTMSMUyRdkx9f~5I8sQ9D5rp2p1VbNfx6bUwX4NUgD4bKaTiQc9nWg4IEGwkTm3Qs2sH94pnsHbMxUWQHANyWgpEzHhieO0YcVzkYaQdpv6vx-ug85-3kYMOAjZylJ9ewcjeh0hV~qlyYDa8w6GZ8jGwyVG3WrgYpA3iAz1aHhwTxeUSup1GG-Qqv0YR~ltxJkXYbWDVrSzw__&Key-Pair-Id=APKAJLOHF5GGSLRBV4ZA |access-date=29 October 2020}}{{dead link|date=May 2021|bot=medic}}{{cbignore|bot=medic}}</ref> mentioned that agents who receive compensations such as praises, acknowledgement and recognition help to define intrinsic motivations that increase performance output from the agents thus benefiting the principal.

Furthermore, the studies provided a conclusive remark that intrinsic motivation can be increased by utilising the use of non-monetary compensations that provide acknowledgement for the agent. These higher rewards, can provide a principal with the adequate methodologies to improve the effort inputs of the agent when looking at the principal agent theory through an employer vs employee level of conduct.

===Team production===
On a related note, Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers. This negative effect is particularly important in those jobs that involve strong elements of "team production" ([[Alchian]] and Demsetz 1972), where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team. In other words, pay-for-performance increases the incentives to free-ride, as there are large positive externalities to the efforts of an individual team member, and low returns to the individual (Holmström 1982, McLaughlin 1994).

The negative incentive effects implied are confirmed by some empirical studies, (e.g., Newhouse, 1973) for shared medical practices; costs rise and doctors work fewer hours as more revenue is shared. Leibowitz and Tollison (1980) find that larger law partnerships typically result in worse cost containment. As a counter, peer pressure can potentially solve the problem (Kandel and Lazear 1992), but this depends on peer monitoring being relatively costless to the individuals doing the monitoring/censuring in any particular instance (unless one brings in social considerations of norms and group identity and so on). Studies suggest that profit-sharing, for example, typically raises productivity by 3–5% (Jones and Kato 1995, Knez and Simester 2001), although there are some selection issues (Prendergast).

===Empirical evidence===
There is however considerable [[empirical evidence]] of a positive effect of compensation on performance (although the studies usually involve "simple" jobs where aggregate measures of performance are available, which is where piece rates should be most effective). In one study, Lazear (1996) saw productivity rising by 44% (and wages by 10%) in a change from salary to piece rates, with a half of the productivity gain due to worker selection effects. Research shows that pay for performance increases performance when the task at hand is more repetitive, and reduces performance when the task at hand requires more creative thinking.<ref>{{cite book |title=Drive: The Surprising Truth about What Motivates Us |first=Daniel H. |last=Pink |year=2009 |location=New York |publisher=Riverhead Books |isbn=9781594488849 |url-access=registration |url=https://archive.org/details/drivesurprisingt00pink_0 }}</ref>

Furthermore,<ref>{{cite journal |last1=Haubrich |first1=Joseph |title=Risk Aversion, Performance Pay, and the Principal-Agent Problem |url=https://www.journals.uchicago.edu/doi/pdf/10.1086/261931 |journal= Journal of Political Economy |year=1994 |volume=102 |issue=2 |pages=258–276 |doi=10.1086/261931 |s2cid=15450754 |access-date=29 October 2020}}</ref> formulated from their studies that compensation tend to have an impact on performance as a result of risk aversion and the level of work that a CEO is willing to input. This showed that when the CEO returned less effort then the data correlated a pay level of neutral aversion based on incentives. However, when offered incentives the data correlated a spike in performance as a direct result.

Conclusively, their studies indicated business owner (principal) and business employees (agents) must find a middle ground which coincides with an adequate shared profit for the company that is proportional to CEO pay and performance. In doing this risk aversion of employee efforts being low can be avoided pre-emptively.

* Paarsch and Shearer (1996) also find evidence supportive of incentive and productivity effects from piece rates, as do Banker, Lee, and Potter (1996), although the latter do not distinguish between incentive and worker selection effects.
* Rutherford, Springer and Yavas (2005) find evidence of agency problems in residential real estate by showing that real estate agents sell their own houses at a price premium of approximately 4.5% compared to their clients' houses.
* Fernie and Metcalf (1996) find that top British jockeys perform significantly better when offered percentage of prize money for winning races compared to being on fixed retainers.
* McMillan, Whalley and Zhu (1989) and Groves et al. (1994) look at Chinese agricultural and industrial data respectively and find significant incentive effects.
* Kahn and Sherer (1990)find that better evaluations of white-collar office workers were achieved by those employees who had a steeper relation between evaluations and pay.
* Nikkinen and Sahlström (2004) find empirical evidence that agency theory can be used, at least to some extent, to explain [[financial audit]] fees internationally.
* Piezunka and Grohsjean (2023) theorize (and provide corresponding empirical evidence from the [[Video game industry]]) that organizations sometimes enter interorganizational relationship that foster the careers of the organization's employees, but undermines the performance of the organizations products.<ref>{{Cite journal |last=Piezunka |first=Henning |last2=Grohsjean |first2=Thorsten |date=2023 |title=Collaborations that hurt firm performance but help employees’ careers |url=https://sms.onlinelibrary.wiley.com/doi/10.1002/smj.3447 |journal=Strategic Management Journal |language=en |volume=44 |issue=3 |pages=778–811 |doi=10.1002/smj.3447 |issn=1097-0266|doi-access=free }}</ref>  
* There is very little correlation between performance pay of CEOs and the success of the companies they manage.<ref>{{cite journal |journal= Journal of Political Economy |url= https://www.jstor.org/stable/2937665 |title=Performance Pay and Top-Management Incentives |last1=Jensen |first1=M. C. |last2=Murphy |first2=K. J. |date= 1990 |volume= 98 |issue= 2 |pages= 225–264 |doi= 10.1086/261677 |jstor= 2937665 |url-access= subscription }}</ref>