Part IIB – Industry Empirical Studies Lecture 8: Contracts, Incentives ...

Introduction
Part IIB – Industry
Empirical Studies
Lecture 8: Contracts, Incentives and
Organization Structure
Dr Christos Genakos
• So far in the course, we have treated firms as black boxes
maximizing their output given their inputs
• Today we are going to take a step back and look inside this
black box
• Fundamental question: Why do firms exist?
• Firms exist to coordinate and motivate people’s economic
activity (why inside the firm and not in the market place?)
• Coordination means, at a minimum, that all needed tasks
are completed without pointless duplication
• Motivation becomes a problem too if it’s not automatically in
the self- interest of individuals to act in ways that promote
realizing an efficient solution to the coordination problem
• Assume that firms exist, look at the source and nature of
motivation problems and in ways to organize the firm for
performance
Introduction
• Main motivation or incentive problems inside the firm:
• Externalities: people’s actions affect others in ways that the
individual does not fully take into account
• Moral hazard: limited observability of actions, cannot specify
rewards and punishments at an individual level
• Free riding: several people contribute to some outcome but
all share the benefits
• All these situations fall under the rubric of “agency
problems”
• The key problem:
– an agent acts on behalf of another, called the principal
– other things being equal, at the margin the agent prefers
to provide less of the action taken on the principal’s
behalf while the principal prefers more
Introduction
• If the agent’s effort were observable and verifiable to the
courts, then the two parties could simply contract on the
action taken
• Assume principal cannot directly observe the agent’s
actions, but can observe a noisy signal (effort + noise)
• If the agent bore the full benefits and costs of his actions, he
would take the efficient choices
• If agent is risk averse or financially constrained, he cannot
be the full residual claimant
• The principal’s problem is to design an incentive scheme
that trades off the cost of having to compensate the agent
(extra effort and for bearing risk) against the benefits
generated by the extra effort induced by stronger incentives
OUTLINE Performance Pay and Productivity – Lazear (2000)
1. Performance Pay and Productivity – Lazear (2000)
2. IT, Workplace organization and the demand for Skilled
Labor – Bresnahan, Brynjolfsson and Hitt (2002)
3. Measuring and Explaining Management Practices across
firms and countries – Bloom and Van Reenen (2007)
• Basic cornerstone of theory is that workers respond to
incentives
• But there is intrinsic as well as extrinsic motivation
• Sociologists claim that monetarizing incentives may
actually reduce output
• Lazear looks at the data from a single company (Safelite
Glass Corp.) which during 1994- 95 gradually changed the
compensation method from hourly wages to piece- rate pay
• One company, but very good data: 3,000 employees over
a 19- month period working under both contracts
• Output easy to measure: auto glass installation (outputper-
worker- per- day)
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Performance Pay and Productivity – Lazear (2000)
Performance Pay and Productivity – Lazear (2000)
The new contract offered a guarantee at approximately the
former wage: paid W to anyone earned less than W under
the piece rate, but paid the piece rate to all of those whose
composition by the piece- rate formula would have
exceeded W
Theory tells us that:
Effort does not decrease when the firm switches, and as
long as there are some high ability workers, average effort
increases
A sufficient condition for the range of worker ability and
output to rise after the switch is that some workers choose
to work enough to be in the piece- rate range (variability of
output is expected to rise)
Data: information on approx. 3,000 workers producing before
and after the switch in contracts, productivity: average
number of units installed by a given worker during a given
month
Results:
Performance Pay and Productivity – Lazear (2000)
Discussion
Results
1. 44% gain in productivity when switch to piece rates
2. Approximately half of the increase in productivity reflects
an incentive effect
3. Sorting accounts for the rest (new workers hired after the
switch are more productive)
4. Learning is important
5. There is no Hawthorne effect (ANY change is likely to
bring short term gains in productivity)
6. Unlikely that the effect is spurious (rolled out
geographically)
7. Also wages rise 7%, so both capital and labor better off
(not necessarily the case according to theory)!
Output easily measured, quality problems readily detected
and blame is assignable few similar workplaces
If work is multi- tasking very expensive to provide explicit
incentives for all tasks and if you give incentives only for
some tasks people are going to do just that!
People might start manilupating their performance
measures (Oyer, 1998)
Even worse workers might start sabotaging their coworkers
(Garicano, Palacios- Huerta 05)
Reputation and creating a “culture”
OUTLINE
1. Performance Pay and Productivity – Lazear (2000)
2. IT, Workplace organization and the demand for Skilled
Labor – Bresnahan, Brynjolfsson and Hitt (2002)
3. Measuring and Explaining Management Practices across
firms and countries – Bloom and Van Reenen (2007)
IT, Workplace organization and Skilled Labor – Bresnahan,
Brynjolfsson and Hitt (2002)
Key concept: complementarity
Two choice variables are complements when doing one of
them increases the returns to doing the other
Neither the investments nor the organizational changes might
be worthwhile on their own, but together they have a huge
positive effect on performance
Background: Skill- biased technical change means that
technical progress shifts demand towards more highly
skilled workers relative to less skilled
Not all technological revolutions were skilled biased, IT is!
BBH question: How information technology is used in
production?
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IT, Workplace organization and Skilled Labor – Bresnahan,
Brynjolfsson and Hitt (2002)
BBH: “Firms do not simply plug in computers or
telecommunications equipment and achieve service quality or
efficiency gains. Instead they go through a process of
organizational redesign and make substantial changes to their
product and service mix. This raises the possibility that
computers affect labor demand not only directly, as has been
previously studied, but indirectly through other firm-level
changes.”
In other words, to realise the IT benefits firms also need to
invest in changes in organization practices and changes in
products and services taken together
IT, Workplace organization and Skilled Labor – Bresnahan,
Brynjolfsson and Hitt (2002)
Declines in IT prices increase adoption and use of IT
increases the economic attractiveness of complementary
investments in work organization and product & service
innovations further increasing demand for IT
Individually and collectively, these three innovations increase
the relative demand for skilled labor
Data:
Panel of IT capital and mix over 1987- 1994
Production function inputs and outputs over 1987- 1994
Cross section survey of organization practices and labor force
characteristics
Approx. 300 large US firms
IT, Workplace organization and Skilled Labor – Bresnahan,
Brynjolfsson and Hitt (2002)
Two empirical specifications. The short run input choice
function:
Qcit = f ( Qc′
it
, controls)
where Q cit are firms’ choices that vary more easily as a function
of the others c’ which are fixed or quasi- fixed at the firm
level. Controls: firm size, industry, production process
proxies
They also estimate production functions of the form:
( S − M ) f ( L , K , Q controls)
log =
it it
it it cit;
Dependent: Log (value added), plus interactions to capture
complementarities
IT, Workplace organization and Skilled Labor – Bresnahan,
Brynjolfsson and Hitt (2002)
Results:
Evidence of complementarities, but also data limitations
A firm high on all three axes (human capital, IT and work
organization) has a 7% increase in productivity to a firm that
is at the mean on all three, over and above the direct effect
of higher IT capital
Even more interestingly, when the authors changed the mix
(high- low- high, etc), predicted productivity falls to worse
than mean in all cases
Low- low- low is exceptional as it has the same predicted
productivity as the mean
“Old style” firms, internal consistency, “coherent
combination”
OUTLINE
1. Performance Pay and Productivity – Lazear (2000)
2. IT, Workplace organization and the demand for Skilled
Labor – Bresnahan, Brynjolfsson and Hitt (2002)
3. Measuring and Explaining Management Practices
across firms and countries – Bloom and Van Reenen
(2007)
Measuring and Explaining Management Practices across
firms and countries – Bloom and Van Reenen (2007)
Large persistent productivity spread across firms and
countries
People typically claim this is due to differences in
“management”
But what is the role of management?
And why does it vary so much across firms and countries?
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STEPS TO TRY TO MEASURE MANAGEMENT
1) Developing management practice scoring
• Scorecard for 18 monitoring, targets and incentives practices
• 45 minute phone interview of (manufacturing plant) managers
2) Obtaining unbiased responses
• “Double- blind”
• Interviewers do not know company performance
• Managers are not informed (in advance) they are scored
3) Getting firms to participate in the interview
• Introduced as “Lean- manufacturing” interview, no financials
• Endorsement of Bundesbank ,UK Treasury, Banque de France
• Run by 10 MBAs (loud, assertive & business experience)
MONITORING - i.e. “HOW IS PERFORMANCE TRACKED?”
Score
(1): Measures
tracked do not
indicate directly
if overall
business
objectives are
being met.
Certain
processes aren’t
tracked at all
(3): Most key
performance
indicators
are tracked
formally.
Tracking is
overseen by
senior
management
(5): Performance is
continuously
tracked and
communicated,
both formally and
informally, to all
staff using a range
of visual
management tools
Note: All 18 dimensions and over 50 examples in Bloom & VanReenen (2006)
MANAGEMENT SURVEY SAMPLE
• US (290), UK, France and Germany (≈150 each)
• Medium sized manufacturers (100 - 10,000 employees,
median ≈ 600)
• Medium sized because firm practices more homogeneous
• Manufacturing as easier to measure productivity
• Obtained 54% coverage rate from sampling frame
• Response rates uncorrelated with performance measures
INTERVAL VALIDATION OF THE SCORING
• Re- interviewed 64 firms with different interviewers and managers
Firm average scores (over 18 question)
2 nd interview
5
4
3
`
2
• Firm- level average
correlation of 0.759
1
1 2 3 4 5
1 st interview
EXTERNAL VALIDATION OF THE SCORING
Performance
measure
country c
c
c c
c c c c c
y c c
it
= βMNGi
+ α llit
+ α kkit
+ α mmit
+ γ ' xit
+
management
ln(capital) other controls
(average z- scores) ln(labor) ln(materials)
• Use up to 11 years of accounting data for 1994- 2004
• Note – not a causal estimation, only an association
u
c
it
EXTERNAL VALIDATION: PRODUCTIVITY & PROFIT
Dependent
variable
Sales
(in Ln)
Sales
(in Ln)
Sales
(in Ln)
ROCE
Tobin Q
(in Ln)
Sales
growth
1
Management i
Estimation OLS OLS OLS OLS OLS OLS Probit
Firms
All All All All Quoted All All
0.085 0.034
0.042 2.469
0.250 0.018
(0.025) (0.011)
(0.012) (0.688)
(0.075)- (0.006)
-0.200
[0.026]
Controls 1 No Yes Yes Yes Yes Yes Yes
Ln(Labor) it
0.999 0.539
0.540 2.172
0.209 -0.022
(0.014) (0.021)
(0.021) (1.202)
(0.109) (0.011)
0.233
[0.045]
0.103
0.104 -0.148
-0.029 0.024 -0.158
Ln(Capital) it (0.013)
(0.013) (0.899)
(0.086) (0.008) [0.045]
Ln(Materials) it
0.362
0.354 -0.439
0.130 -0.010 -0.084
(0.020)
(0.020) (0.723)
(0.050) (0.007) [0.231]
Noise controls No No Yes Yes Yes Yes Yes
Observations 6,267 5,350 5,350 5,089 2,635 4,777 709
Firms
732 709 709 690 374 702 709
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Includes country, year, SIC3 industry, skills, hours, firm-age, and public/private
Robust S.E.s in ( ) below. For probit p-values in [ ] below
Exit
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FIRM LEVEL AVERAGE MANAGEMENT SCORES
Density
Density
.6 0 .2 .4 .6 .8 1 1.2 0 .2 .4 .8 1 1.2
France n=137 Germany
n=157
1 2 3 4 5
UK
n=154
Density
Density
.6 0 .2 .4 .6 .8 1 1.2 0 .2 .4 .8 1 1.2
1 2 3 4 5
US
n=290
COUNTRY LEVEL MANAGEMENT SCORES*
US
Germany
France
UK
3.14
3.07
3.35
3.31
Bad manufacturing management - a UK tradition?
Typical UK managers?
“Efficient management is the single most significant factor
in the American productivity advantage”
[Marshall Plan Anglo- American productivity mission, 1947]
1 2 3 4 5
1 2 3 4 5
Measuring and Explaining Management Practices across
firms and countries – Bloom and Van Reenen (2007)
Demonstrate that two factors appear significant:
Production market competition – positive effect
Family managed firms – negative effect
Family firm ownership but not management is fine
Family ownership and management problematic, particularly
under primo geniture CEO succession
Competition and family- management important, explains
about 50% of firm- level management tail; and between 1/3 to
2/3 of US- Europe management gap:
– Europe has lower levels of competition
– UK & France also many more primo geniture family firms
due to Norman legal origin & tradition
Management Practices across Europe, the US and Asia –
Bloom, Genakos, Sadun and Van Reenen (2008)
Extend this methodology to 13 different countries across
Europe, US and Asia
Interview more than 4,000 firms
Data also on their production function inputs
Is there a role for management practices? Historically there
was no international management data
LINKED TO PERFORMANCE IN ALL THE
COUNTRIES (NOT JUST ANGLO-SAXON ONES)
Labor Productivity
Labor Productivity
/em ployee (in logs) - b asi c labor p roductivity m easure - ra w num bers
4 5 6 7
/em ployee (in logs) - b asi c labor p roductivity m easure - ra w num bers
3 4 5 6 7
US & UK
1 2 3 4 5
Our management score - average across 18 questions
Management
Greece, Portugal & Italy
1 2 3 4 5
Our management score - average across 18 questions
Management
Labor Productivity
/em ployee (in lo gs) - basic la bor prod uctivity m e asure - raw num bers
2 4 6 8
/em ployee (in logs) - b asi c labor p roductivity m easure - ra w num bers
2 4 6 8
Japan & China
1 2 3 4 5
Our management score - average across 18 questions
France, Germany, Sweden & Poland
Labor Productivity
Management
1 2 3 4 5
Our management score - average across 18 questions
Management
HETEROGENEITY IN MANAGEMENT SCORES BY
COUNTRY
Average management score, by country
U.S.
Germany
Sweden
Japan
Italy
UK
France
Poland
Portugal
Greece
China
India
2.73
2.64
2.63
2.62
3.00
3.00
2.99
2.88
3.30
3.17
3.15
3.15
3 statistically distinct
groups appear
– U.S., Germany,
Sweden and
Japan
– Italy, U.K.,
France, and
Poland
– Portugal,
Greece, China
and India
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BUT THE US IS NOT BEST AT EVERYTHING - THERE
ARE NATIONAL STRENGTHS & WEAKNESSES
Greece
Portugal
India
China
Italy
France
Sweden
Poland
Japan
UK
Germany
US
People management
Operations management
0 1 2 3 4
The US is world
leading in people
management, but
Germany, Sweden
and Japan are
better on average
at operations
management
MULTINATIONALS ARE WELL RUN EVERYWHERE
Greece
India
Portugal
China
Poland
France
UK
Italy
Germany
Sweden
Japan
US
Multinationals
Domestic firms
Multinational
presence also
appears to be
linked with
better
management of
domestic firms
0 1 2 3 4
THE AVERAGE MANAGER ALSO THINKS HIS FIRMS
MANAGEMENT IS WELL ABOVE AVERAGE
Share D en sity of firms
0 .1 .2 .3
“Worst
Practice”
Response to the Question
“Excluding yourself, how would you
rate your company’s management
from 1 to 10, one being the worst
and ten being the best?”
“Average”
1 2 3 4 5 6 7 8 9 1 0
Management self-score
“Best
Practice”
AND THIS OVER-SCORING OCCURS IN EVERY
COUNTRY IN OUR SAMPLE
China
Greece
India
Portugal
Poland
Italy
France
UK
Japan
Sweden
Germany
US
0 1 2 3 4
Actual score
Self score*
* Divided by 2 to normalize to a similar scale
SUMMARY
1. Innovative survey tool to collect management practice data
for over 4000 firms across 13 countries
2. Better management practices are strongly associated with
superior firm performance
3. Significant within country variation in management practices
4. Key factors that can potentially explain this heterogeneity
include: competition, type of ownership, MNE’s, skills,
regulation and education.
Contracts, Incentives and Organization Structure:
References
* Lazear, E. (2000) “Performance Pay and Productivity”,
American Economic Review, 90:1346-61.
* Bresnahan, T., Brynjolfsson, E. and L. Hitt (2002) “Information
Technology, Workplace Organizationa dn the Demand for Skilled
Labor: Firm-level evidence”, Quarterly Journal of Economics,
February 339-376.
* Bloom, N. and Van Reenen, J. (2007) “Measuring and
Explaining Management Practices across firms and countries”,
Quarterly Journal of Economics, November 1351-1408.
It was hard work but…?
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