Attacking Incentive Pay is the “Height of Irresponsibility”

2 February 2009 at 11:11 am 13 comments

| Peter Klein |

Imagine you’re a salesperson at a company. In order to create an incentive for you to bust your tail, the company negotiates with you a leveraged compensation plan under which you receive a relatively small base salary plus fairly generous commissions on the sales you close. Suppose you do a bang up job one year, but the company as a whole suffers a loss because of some poor decisions beyond your control (or because of developments in the macroeconomy, such as the bursting of an asset bubble facilitated by government-sponsored entities). Now imagine that the government perceives your company to be strategically important and therefore decides to subsidize it by, say, buying its preferred stock or extending it a loan. Would it be “the height of irresponsibility” for your employer to honor your legitimate compensation expectations and pay you the wages that you effectively earned under your implicit deal with the firm? And what would happen if your employer didn’t pay you what you legitimately expected? Wouldn’t you and the other successful salespeople at your company immediately bolt, leaving the company with a much less effective sales force?

I have little to add to Thom’s excellent post on Obama’s populist attack on bonuses except to note that the compensation system is just one element of a firm’s organizational architecture (along with the allocation of decision rights, systems of performance evaluation, and so on). The firm, as Holmström and Milgrom put it, is an incentive system, and the elements of this system interact in complex and nuanced ways. The idea that regulators can simply march in and dictate changes to one element or another, based on popular prejudice, without affecting the performance of the system, is typical of the hubris of the intellectual.

Entry filed under: - Klein -, Corporate Governance, Management Theory, Strategic Management, Theory of the Firm.

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13 Comments Add your own

  • 1. Andre Sammartino  |  2 February 2009 at 5:20 pm

    Of course, this component of the quote is highly dependent on there being sufficient labour demand (and/or flexibility for other non-affected firms to shuffle their employment mix):

    “And what would happen if your employer didn’t pay you what you legitimately expected? Wouldn’t you and the other successful salespeople at your company immediately bolt, leaving the company with a much less effective sales force?”

    But your/their point stands as a worthy one.

  • 2. Steve Phelan  |  2 February 2009 at 6:38 pm

    So let’s imagine a car salesman who makes his annual sales target by selling lemons (let’s say the cars were all flooded in a hurricane). Let’s also assume that all these lemons passed a Carfax check that essentially reported “no known flood damage”.

    Unbenowst to the buyer, the salesman was able to get an “advisory opinion” from Carfax (and other rating agencies) before a formal report was issued and the salesman was able to go with the most favorable report (a report the car dealership paid for). Let’s also assume that the dealership issues a two-year warranty on cars sold.

    A year later all the new owners are seeking warranty work, threatening the dealership was bankruptcy. In a magnanimous gesture the government decides that car dealerships cannot be allowed to fail so the government starts bailing out dealerships by providing taxpayer money to pay for the estimated warranty liabilities.

    The salesman then requests his bonus for all the sales he made in the preceding year (and wants to use government money to pay for it). The general manager of the dealership (who turned a blind eye to the practice of shopping lemons) also wants to use government money to pay his bonus. Do these employees have a “legitimate compensation expectation”? In what way were the “poor decisions beyond your control” if you were the salesperson or general manager? Should the taxpayer be outraged at their claims?

  • 3. Anthony  |  2 February 2009 at 7:43 pm

    Re: Steven Phelan

    Excellent point, but I would argue taxpayers should be outraged the government decided dealerships peddling ‘lemons’ cannot be allowed to fail.

  • 4. Peter Klein  |  2 February 2009 at 8:47 pm

    Steve, let’s stick with your example for a moment.

    1. Would an industry-wide ban on bonus payments, in the middle of the compensation period, regardless of (a) how many (if any) “lemons” a particular employee sold, (b) what other elements are in the employee’s compensation package, (c) what decision rights the employee holds over what is sold, how products are priced, marketed, rated, etc., and (d) whether the employee’s firm received public funds, be an appropriate policy response to the situation you describe?

    2. Getting incentives right is no easy task, as I tried to suggest above. All forms of compensation have benefits and costs that have to be balanced carefully, at the margin. Firms often make mistakes, and their performance tends to suffer as a result. If auto dealerships were to employ a system, by design or by accident, that gives salespeople incentives to push lemons, is it better to rely on market discipline to make them mend their ways (as Anthony’s comment suggests), or to ban an entire class of performance incentives?

    Back to the case at hand: What could President Obama possibly know about the details of the bonus payments he now attacks? Who exactly got them and under what circumstances? What are the relevant pay-for-performance sensitivities? He hasn’t the faintest idea. He is simply exploiting public sentiment against “Greedy Wall Streeters.” More generally, do we really want the Federal government deciding what organizational architectures are OK?

  • 5. Steve Phelan  |  3 February 2009 at 12:00 am

    @ Anthony

    I agree.

    @ Peter

    1. No, it would not.

    2. It is better to rely on market incentives.

    3. My argument is that the banks made record profits by selling lemons and now they are insolvent (literally not technically). The Dow also returned its worst performance since the Great Depression. Given these facts, the public (and President Obama) is quite justified in thinking something fishy is going on if general managers can get rewarded for non- (or pseudo) performance in the recent past. But you are right, he can’t possibly know the details. However, if it quacks like a duck…

    P.S. When a corporation accepts a taxpayer-funded bailout in lieu of the discipline of the market then the government DOES get a say in organizational architectures.

  • 6. Peter Klein  |  3 February 2009 at 11:32 am

    Steve, my response regarding #3 is that you are operating at too high a level of aggregation. It’s not what “the banks” did and how the Dow performed and that “managers” are being rewarded for poor performance, it’s what particular banks and particular managers did. Of course I opposed bailing out any of the banks, but given that the bailouts occurred, I can understand why policymakers (and the public) are attracted to micromanagement. Even so, I don’t see how a blanket condemnation of an entire class of compensation policy helps.

  • 7. Mike Sykuta  |  3 February 2009 at 11:57 am

    Steve,

    Although the market was down, we don’t know how any individual broker’s portfolios performed relative to the market performance. As I tried to explain to one of my classes last week when this issue broke, if my portfolio went down only 30% when the market was down 40% for the year, then my portfolio manager may have done exceptionally well for me and may deserve a bonus–particularly if that bonus was contractually tied to performance relative to the market.

    Many incentive systems are not based (exclusively at least) on absolute performance that may be more sensitive to general uncertainties, but on relative performance that is intended to isolate (insofar as possible) the idiosyncratic performance of the worker. How the market as a whole did is much less relevant in this situation than the Obama administration and the press seem to understand (or are willing to admit). As Peter suggests above, it’s an aggregation problem…especially when we don’t have details about the who and why of the individual bonuses.

  • 8. Steve Phelan  |  3 February 2009 at 1:24 pm

    Peter and Mike, what I hear you saying is that there could be some legitimate compensation among the bonuses. Of course there might be – we have no idea how many of the bonuses were legitimate or not. But, overall, the incentives in place were maladaptive – this was not some big economic tsunami that was “out of the bank’s control” as Thom suggests.

    So, given the market will not have the opportunity to “discipline” these poor incentive schemes shouldn’t you be arguing that these firms are insolvent and thus NO bonuses should be paid (as would likely be the case in the free market if these firms went bankrupt)? A bankruptcy administrator or trustee must make administrative decisions such as these all the time – would it be better if the government appointed a bankruptcy trustee to each firm that receives bailout funds?

    P.S. This is no way suggests that the government should legislate out of existence a whole class of compensation

  • 9. Peter Klein  |  3 February 2009 at 1:30 pm

    “Would it be better if the government appointed a bankruptcy trustee to each firm that receives bailout funds?”

    Possibly, but the problem is that TARP funds have not gone, and are still not going, to banks that are in particular financial distress, but to banks that are politically connected or whose rescue serves some policy end unrelated to the soundness of that particular bank. It’s common knowledge that many banks were compelled to accept bailout money to avoid harming the reputations of those banks that got TARP funds because they actually needed them. So in general, no, I would say that bundling TARP funds with this type of government oversight is likely to make a bad situation worse.

    It would have better, of course, to let insolvent financial institutions actually go bankrupt, and have a real bankruptcy judge make the kinds of decisions you’re describing!

  • 10. Steve Phelan  |  3 February 2009 at 2:14 pm

    Yes, the whole process was poorly handled. So starting now (and avoiding words like ought and should), what are the microeconomic policy prescriptions for bailed out firms? Should they be treated like solvent or insolvent firms? Should they have a free hand in devising compensation schemes that involve taxpayer money?

    My two cents worth is that they should be treated like insolvent firms and have an administrator appointed by a bankruptcy court (with some rules for removing the administrator once the firm is solvent). The incentive to accept a TARP handout would certainly disappear once some “strings” are attached.

  • 11. David Hoopes  |  4 February 2009 at 1:05 am

    My problem with a lot of this is that it seems like one set of people encouraged Fanny and Fredie to reward banks for making loans to high risk people, blocked any attempts at increasing accountability and reserves for such loans (see what B. Clinton said about the Democratic congress on this), support the “bailout” of poorly run banks, and appoint their friends to run the banks being bailed out. Let the banks fail. Let another bank buy their assets. Let the successful banks expand their success by more efficiently managing the failed banks assets.

    Granted, there may not be a person who was in on each phase of my story. However, there are plenty who were in on more than three phases.

  • 12. steve phelan  |  4 March 2009 at 12:41 am

    Take away incentives and the salesmen become order takers Trust me , as a sales manager, I know! The people making the bailout decisions probably have not been in the real work world and seem to just want to keep putting Bandaids on a serious wound that needs surgery. By the way, I am a different Steve Phelan than the one first commenting on this subject. Steve Phelan

  • 13. franck's blog  |  12 December 2009 at 6:11 am

    What’s Wrong with Bonuses?…

    It has been proven time and time again that in order to succeed firms need to be flexible and adaptable. One of the most effective tools available has been bonuses. If you work hard you get a reward, if not you don’t. If times are good you get a big ….

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