Optimal Incentive Contracts for Teams

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Much of the existing theory of incentives describes a relationship that lasts for just one transaction. Except for a few recent articles, the view emerging from these static models promotes incentive schemes that are sensitive to employees' individual performance measures and encourage competition among employees through tournaments or relative performance evaluation. The static nature of these models is not only unrealistic, given that most real world organizations have long, often open-ended, life spans, but their predictions appear to be at odds with many (long-term) agency relationships. Incentives for many employees are often muted, and firms increasingly rely on `self-managed teams` that encourage cooperative relationships among their members through mutual accountability, group incentives and delegated authority. While there has been no firm proof of their benefit, many prominent firms attribute their productivity gains and high performance records to the successful operation of work teams. Several recent authors such as Holmstrom, Milgrom and Itoh demonstrated the benefits of inducing cooperation among workers through team-based incentives. The static nature of these papers leaves unexplained how cooperation among agents can be achieved, however. This project remedies this limitation by focusing on the repeated nature of agency relationships. Doing so not only enables us to explain cooperation among agents as self-enforcing behavior, but it also yields much richer, interrelated predictions on various aspects of internal organization. The new element in the proposed model, absent in the static models, is the possibility of an `implicit incentive` being created. Agents can be induced to monitor and punish one another's shirking, when appropriately motivated by the explicit incentives designed by the principal. The objective of the study is to explore how the implicit incentives can be optimally induced by, and combined with, explicit incentives. This project will provide useful insights on important issues such as the design of pay-for-performance scheme, task assignment, allocation of authority, and the role and value of communication. The preliminary research suggests that the optimal incentive scheme displays many observed features of team arrangements. Specifically, it predicts that relationships with long life spans and mutual accountability are likely to be characterized by low-powered, group incentives and by a high degree of delegation of authority, whereas relationships with short life spans or no mutual accountability are characterized by high-powered, competitive incentive schemes such as relative performance evaluation and tournaments and by a high degree of centralized control and supervision. These findings show a great deal of promise for a theory that will contribute not only to the development of the principal-agent literature but also to the understanding of general incentive issues arising in dynamic agency relationships. The project has direct applications in identifying the benefit of team-based organizations but it will also shed light on other institutions such as group-based lending programs and Japanese subcontracting relationships.