Incentives II. Ideas from Behavioral Economics for Understanding Incentives in Organizations

Transcription

1 . Ideas from Behavioral Economics for Understanding Incentives in Organizations CLSRN Summer School June 2013 Introduction This lecture considers applications from behavioral economics that are working their way into labor economics. The focus almost exclusively is on behavioral aspects of agency. In most cases, the contribution from behavioral economics comes in the form of nonstandard preferences (e.g., social preferences).

2 In the first lecture, we looked at three basic models of imperfect or incomplete information: Moral Hazard. The uninformed party has imperfect information about actions taken by a second party, and the uninformed party moves first. Adverse Selection. The uniformed party has incomplete information about the characteristics or traits of the informed party. The uniformed party moves first. Signaling. The uniformed party has incomplete information about the informed party, but the informed party moves first.

3 Analysis of moral hazard leads to observations about incentives regarding individual pay; team-based incentives (which can have important effects on hierarchical structures in firm); and key consequences for labor markets generally, as in the case of efficiency wages, which can result in equilibrium unemployment or dual labor markets. Examples of signaling include the worker signaling the firm, as in Spence s model, and the firm signaling workers, as in the Ritter-Taylor model. An example of adverse selection in the labor market is Akerlof s rat race model. Behavioral Approaches to Agency and Motivation We ll be using the same basic tools in today s lectures. But we also introduce of elements intended to shore up the psychological foundation of agency models. As Camerer and Loewenstein (2004) suggest, Theories in behavioral economics... strive for generality e.g., by adding only one or two parameters to standard models. Particular parameter values then often reduce the behavioral model to the standard one, and the behavioral model can be pitted against the standard model by estimating parameter values. Once parameter values are pinned down, the behavioral model can be applied just as widely as the standard one

4 Pay Status: Incentives and Inequality Aversion When it comes to material well-being, people dislike being low on the totem pole (Frank, 1984, 1985). This idea suggests including asymmetric inequality aversion into utility functions. Fehr and Schmidt (1999) is an important paper that investigates the consequences of a particular form of social preference inequality aversion. Fehr and Schmidt introduce this idea in a behaviorally stripped-down way; for instance, intentionality is absent from this model. Fehr-Schmit: Let x 1, x 2,...x n be monetary payoffs to n individuals. The utility of player i depends on everyone s payoff; u i (x 1,...,x n )is x i α i j i max[x j x i, 0] n 1 where β i α i and 0 β i. β i j i With two players, utility for player 1 is just max[x i x j, 0], n 1 u 1 (x 1, x 2 )=x 1 α 1 max[x 2 x 1, 0] β 1 max[x 1 x 2, 0].

5 A nice application is to an ultimatum game. A proposer offers to divide a fixed amount of money between himself and a responder. The responder can accept or reject this offer. If the offer is accepted, money is divided accordingly. If the offer is rejected, however, neither party gets any money. Solutions: With conventional preferences, the solution is for the proposer to propose to keeps all (or nearly all) of the money. The responder then accepts. The solution is different with Fehr-Schmidt preferences. If the proposer s offer generates too much inequality, the responder rationally rejects. Knowing this, the proposer makes a reasonably generous offer. Fehr and Schmidt s Proposition 1: Responders reject offers if they are too unfair, so in turn proposers make offers in which the share offered, s, is closer to 1 2 than would be predicted with conventional preferences. Fehr and Schmidt s Proposition 2: Now consider a game in which there are several proposers, and the responder gets to choose from among them. In this case, even with the Fehr-Schmidt preferences, the subgame equilibrium entails at least two proposers offering s =1. The point is that people may care about inequality, but in a setting where competition matters, there s nothing they can do about it. Equilibrium is the same with inequality aversion as with normal preferences.

6 We can try Fehr-Schmidt preferences in examples from Lecture I. Example 1. The Tournament Model Instead of having agent utility u = w e, try { w0 + b δ utility = W b e for winners, and w 0 δ L b e for losers. δ W 0 reflects empathy winners feel for losers; δ L >δ W indicates that losers suffer a larger utility loss due to inequality aversion. It is easy to show that the firm reduces the bonus awarded to the winner, and settles for a second-best effort level, e < e. Inequality aversion leads the firm to compromise lowering incentive pay, which reduces effort elicited. Should P be set near 0 (so there are few losers)? Are there steps firms can take to reduce the corrosive effects of inequality? Is it a good idea to dismiss the losers? Example 2. Rent Sharing If the agent compares her income to the principal s income, the result might be rent sharing. Reducing wages to the level of an employee s outside option can be self-defeating in this context because it risks that the agent will become disgruntled and take steps to even the score.

7 Does any of this matter in real-world markets, or does competition drive out the role of inequality aversion? Fehr and Schmidt (1999) argue:... competition renders fairness considerations irrelevant if and only if none of the competing players can punish the monopolist by destroying some of the surplus and enforcing a more equitable outcome. This suggests that fairness plays a smaller role in most markets for goods than in labor markets. This follows from the fact that, in addition to the rejection of low wage offers, workers have some discretion over their work effort. By varying their effort, they can exert a direct impact on the relative material payoff of the employer. The Fehr-Schmidt conjecture has been examined in many experiments; see Fischbacher, Fong and Fehr (2009), and reference therein. In their experiments, increasing proposer competition in the Ultimatum Game, by adding extra proposers, causes an increase in mean accepted offers, while increasing responder competition reduces mean accepted offers.

8 As for labor markets more generally: The idea that workers exact retribution upon employers when treated unfairly is supported by Bewley s (1999) extensive qualitative interviews. Mas (2006) finds that when New Jersey police lose in final offer arbitration so the wage they receive is lower than the requested wage arrest rates and average sentence lengths decline, while crime reports rise. This is consistent with the idea that workers are less inclined to provide effort when the wage falls below a salient reference. Krueger and Mas (2004) report that a contentious strike and the hiring of replacement workers in a Bridgestone/Firestone plant contributed to the production of defective tires. Mas (2008) finds Caterpillar plants that underwent contract disputes experienced reduced workmanship and reduced product quality. Nagin, Rebitzer, Sanders, and Taylor (2002) look at a non-union environment. We manipulated monitoring levels at call centers. We had (i) a direct measure of malfeasance by individual employees and (ii) measures of employee perceptions about the employer. When given the opportunity, malfeasance was most prevalent among workers who had expressed feelings that the employer treated them unfairly, did not care about them, and provided a bad place to work.

9 Effort Norms Akerlof s (1982) model of gift exchange relies on very different sociological and psychological mechanisms than the standard agency approach. Instead of calculating costs and benefits of working harder, employees in Akerlof s model are motivated by norms governing behavior in the exchange of gifts. Decent people, so the reasoning might go, return kindness with kindness and so, wishing to preserve the self image of decency, an employee responds to a generous wage by returning the favor in the form of high effort. In a simple example, Akerlof shows that the labor market consequence can be unemployment. A nice way to model fairness is found in an important work by Rabin (1993, 2002, etc.). Rabin takes an intention-based approach. People have social preferences in which they have positive feelings about those whom they think are nice. The key assumptions are: People are willing to make material sacrifices to help others who are being kind. People are willing to punish others who are unkind. There are limits to the previous two motivations. An important feature of the framework is that payoffs depend on actions (as usual) and on beliefs. Making attributions about intentions requires the use of a norm.

10 Card, Della Vigna, and Malmendier (2011) give a nice discussion about experimental evidence for understanding gift exchange. The start point is Fehr, Kirchsteiger and Riedl (1993), in which workers respond to generous offers by firms by exerting more effort, as predicted by gift exchange models. Of course lab experiments may not pertain in the real world. Gneezy and List (2006) design a field experiment to see if lab results carry over finding that higher pay leads to greater effort for a while (3 hours), but the effect is short lived. Card, Della Vigna and Malmendier note two models that might provide explanations: inequality aversion (as in Fehr and Schmidt, 1999) or an intention-based approach (like Rabin, 2002). The Fehr-Kirchsteiger-Riedl experiment is consistent with either approach, but the Gneezy-List field experiment cannot be explained by inequality aversion. Instead, there must be some form of social preferences such as reciprocity. There is a growing literature on work norms. Here are some examples: Ichino and Maggi s (2000) study of workers in different branches of a large Italian bank finds peer effects. Falk and Ichino (2006) have a experiment that shows a positive impact on output due to peer effects. In a remarkable study of cashiers at a national supermarket chain, Mas and Moretti (2008) find that substituting a worker with below average productivity for a worker with above average productivity is associated with a 1 percent increase in the effort of other workers on the same shift.

11 Identity Akerlof and Kranton (2005) have interesting recent work on identity. The term identity is used to describe a person s social category a person is a man or a woman, a black or a white, a manager or a worker. The term identity is also used to describe a person s self-image. It captures how people feel about themselves, as well as how those feeling depend upon their actions. In a model of utility, then, a person s identity describes gains and losses in utility from behavior that conforms or departs from the norms for particular social categories in particular situations.... In our conception, utility functions can change, because norms of appropriate and inappropriate behavior differ across space and time. Gender Identity Can identity models generate falsifiable hypotheses? A template might be found in recent work on gender. Women are less likely than men to initiate negotiation (Small, Gelfand, Babcock, and Bettman, 2007). Women do less well than men when negotiating for themselves, but better when negotiating for others (Bowles, Babcock, and McGinn, 2006). Women avoid self promotion. Women fare less well than men in tournament style incentives, and tend to shy away from them (Gneezy, Niederle, and Rustichini, 2003, and Niederle and Vesterlund, 2007). Gender identity, in short, matters. But why? Do women prefer to avoid self-advocacy or do they fear a backlash if they violate feminine norms of kindness and gentility? See Bowles, Babcock, and Lai (2006) on backlash.

12 Here s a study currently being conducted by Linda Babcock. The issue is: Would you rather negotiate or listen to extremely unpleasant sounds? The potential negotiations are about: 1. Payment for a formal dinner party at your dorm. 2. Details linens, glasses, etc. in a formal dinner party at your dorm. Your choice is to negotiate over this...

13 or listen to this: Figure: From Bear, J. and Linda Babcock (2012), Gender Differences in the Decisions to Negotiate: The Moderating Role of Negotiation Topic.

14 Some Models of Intrinsic Motivation Our last part of our lecture looks at intrinsic motives including the possibility that extrinsic incentives can undermine intrinsic motives. Many psychologists believe this idea. See, e.g., the extensive work of Deci. Economists are familiar with work on this topic by Frey, Fehr, Falk and others. We ll thus ask here what happens in be models in which firms have to worry about managing intrinsic motivation. Selection on Dedication Our first example is an adverse selection model in which firms hire workers who have a calling or vocation. There may be many examples of this sort of dedication: the military, religious ministry, policy advocacy, nursing, early childhood education, public-interest law, etc. The calling in this case is a potentially important form of intrinsic motivation.

15 Heyes (2005) looks at the market for nurses: There are L qualified nurses, each of whom falls into two categories: Proportion 1 π view nursing as simply a job. Utility is w. Value produced is q L. Proportion π view work as a vocation. Utility is w + m (where m is positive). Value produced is q H > q L. Nurses of both types have a reservation wage r, drawn from a log concave p.d.f., f (r). So at wage w, the quantity of nursing labor supplied is L(w) =[πf (w + m)+(1 π)f (w)]l, and the average quality is of nursing care is q(w) =θq H +(1 θ)q L, where θ is the proportion for whom nursing is a vocation, θ = πf (w + m)/[πf (w + m)+(1 π)f (w)].

16 Heyes insight is that average quality is declining in the wage; the derivative of θ with respect to w has the same sign as F (w+m) f (w+m) F (w) f (w), which is negative (given log concavity). In Taylor (2007), I find that a monopsonist that maximizes surplus for the organization sets the wage lower than the socially efficient level, but in a perfectly competitive market the wage is inefficiently high. A number of papers explore similar issues: Delfgaauw and Dur (2007) have a wage posting model in which a monopsonist faces the tension discussed above: high wages increase the probability of filling a vacancy, but lower the expected motivation level of applicants. Besley and Ghatak (2005) and Delfgaauw and Dur (2008) study public sector employment when some agents have a public service motivation. Social Preferences and Conformism Sliwka (2007) has a social preference framework model with three types of agents: Steadfast agents who are strictly selfish, steadfast agents who are fair (care about others well-being), and conformists whose inclination is to behave like the majority! In particular, { utility = w(e) e2 2 for a steadfast selfish agent, and w(e) e2 2 + μπ for a steadfast fair agent, where μ reflects a fair agent s level of identification with the principal s objective (with 0 <μ<1).

17 The principal posts a policy w(e) =w 0 + βe; effort is assumed to be observable ex post. The solution works like this: An agent s best response depends on his preferences over effort, and if he is a conformist, also on his perception of the preferences of other workers. If almost all agents are selfish, the principal sets w 0 quite low and β quite high. If almost all agents are fair, lower-powered incentives are used β is lower. Remarkably, a principal who understands that his workforce is comprised predominantly of fair agents can set w 0 high and β low to credibly signal conformists to play fair. Sliwka calls this mechanism trust as a signal of a social norm. There is a lot of evidence on norms the key behavioral underpinning of the Sliwka model. See for examples, Fisman and Miguel (2007), Ichino and Maggi (2000), Mas and Moretti (2009), and Bandiera, Barankay, and Rasul (2005, 2009). Fischer and Huddart (2008) discuss the role of endogenous social norms on organizational design.

18 Impressing the Principal Ellingsen and Johannesson s (2008) model, like Sliwka s, relies on social preferences. But the behavioral mechanisms are quite different. The model has three components: Agents and principals hold social preferences; they care about their own wellbeing and the wellbeing of others. There is unobserved heterogeneity in the extent to which agents and principals value others wellbeing (i.e., the extent to which they are pro-social). Agents and principals are motivated by social esteem: The agent cares about what the principal thinks about her, and the principal cares about what the agent thinks of him. Both want to be thought of as pro-social by the other. Ellingsen and Johannesson s game proceeds as follows: The principal takes an action e.g., a wage offer, or a decision about how much discretion to allow the agent in her work. Then the agent takes an action that affects both her material wellbeing and the principal s wellbeing. There is a set of parameters on preferences and the distribution of types such that a separating equilibrium emerges: A pro-social principal can credible signal that he is pro-social by being generous, and, if she is sufficiently pro-social, the agent responds with an action that benefits the principal. The driving behavioral force? A pro-social agent wishes to be highly regarded by a pro-social principal. Having learned that the principal is pro-social, the agent takes a pro-social action as a means of securing the knowledge that the principal believes her to be pro-social.

19 The Ellingsen-Johannesson approach can rationalize the trust game of McCabe, Rigdon, and Smith (2003): When the principal can trust, the agent often rewards. Principal NT (20,20) Principal T T Agent N R (15,30) (25,25) Agent N R (15,30) (25,25) Impressing Others Bénabou and Tirole s (2006) model of virtue : Agents have varying levels of kindness (concern for others) and temperance (moderation in materialistic pursuit). Take a case where effort e can be 0 or 1. Utility comes from four sources: 1. The agent is other-regarding, earning utility v e e when providing effort e. Individuals with high v e are kind. 2. He earns a material reward in the form of a bonus of b 0, giving utility v m be. Individuals with low v m are temperate. 3. He faces an effort cost of ce. 4. He can gain from the reputation-enhancing effect of choices. Agents want to be known as temperate and kind.

20 Central to the Bénabou-Tirole model are two assumptions, which drive development of reputation: 1. Agents differ in kindness and temperance: An individual s set of preference parameters his identity (v e, v m ) is drawn from a known distribution. 2. Reputation is taken to be other s views of one s identity: R(e, b) =μ e E[v e e, b] μ w E[v m e, b], where μ e and μ w are weights that reflect the degree of image-consciousness (taken to be common knowledge constants here). To summarize, { ve + v utility = m b c + R(1, b) if e = 1 and R(0, b) if e =0. Recall the agent must make a 0/1 effort decision. Effort is 1 if v e + v m b +[R(1, b) R(0, b)] > c. The terms on the left-hand side of this equation are, respectively, the agent s intrinsic, extrinsic, and reputational motivations. Effort is provided when the sum of these motivations exceeds the cost of providing effort. What makes matters interesting is that reputation depends on the level of the bonus b chosen by the principal. To see this, notice: If b = 0, motivation is strictly intrinsic and reputational; effort is provided only if his concern for others exceeds ˆv e : ˆv e c [R(1, 0) R(0, 0)]. b > 0 must reduce reputational value. In the Figure (next slide), identity types in area B reduce effort.

21 Highly pro-social identity types lie to the right of the vertical No Bonus line. What happens when b > 0? Greed (v m ) A Positive Bonus, Unadjusted for Rep. ˆv e No Bonus (b =0) Positive Bonus (b > 0), Adjusted for Reputation B Concern for Others (v e )

22 Impressing One s Own Self Bénabou and Tirole (2006) have an identity interpretation of their model. The reasoning goes as follows: I want to view myself as temperate. I want to view myself as kind. This can lead to crowding out of intrinsic motivation: If you offer me high pay, you deprive me of the opportunity to reinforce my identity. Evidence on Crowding Out There is some evidence of crowding out gathered by economists, in work by Fehr, Falk, Frey, Gneezy, Rustichini, and others. There is a great deal of work in psychology. It is interesting to think about how these findings might apply in labor market settings.

23 A Concluding Puzzle Most economists agree that well designed extrinsic rewards are crucial to the resolution of fundamental and ubiquitous agency problems. It is, as we have seen, possible to construct models where extrinsic rewards undermine intrinsic motives, but these appear largely as elaborations and qualifications of the fundamental message. Matters are quite different in psychology, which has accumulated a vast amount of evidence that extrinsic rewards undermine intrinsic motives. What explains the difference? Final Remarks Rebitzer and Taylor (2011) suggest that many relevant ideas working their way from behavioral economics into agency theory and labor market analysis. Examples include: why inequality aversion sometimes matters, the importance of effort norms and professional norms (and their internal and external drivers), and the role of identity. Promising areas for research might include: the behavioral foundations of conflict of interest, e.g., in the health and financial sectors, better structure in the study of identity, implications of behavioral ideas for labor policy, and further work on the behavioral foundations of intrinsic motivation.

24 Many of the ideas used in these slides are drawn from: Rebitzer, James and (2011), Extrinsic Rewards and Intrinsic Motives: Standard and Behavioral Approaches to Agency and Labor Markets, in Orley Ashenfelter and David Card, editors, Handbook of Labor Economics, vol. 5. Amsterdam: North Holland. Also, most of the references to other research can be found there.