I NCENTIVES ARE the essence of economics. Despite many wide-ranging claims about their supposed importance, there has been little empirical assessment of incentive provision for workers. The purpose of this paper is to critically overview existing work on the provision of incentives. Since the interests of workers and their employers are not always aligned, a large theoretical literature has emphasized how firms design compensation contracts to induce employees to operate in the firm's interest. This literature has reached into many areas of compensation and has pointed to a multitude of different mechanisms that can be used to induce workers to act in the interests of their employers. These include piece rates, options, discretionary bonuses, promotions, profit sharing, efficiency wages, deferred compensation, and so on. My objective here is to evaluate this literature in the light of a growing empirical literature on compensation. Where possible, I will address the literature from two perspectives. First, an underlying assumption of this literature is that individuals respond to contracts that reward performance. Accordingly, I consider whether agents behave in this way, and whether these responses are always in the firm's interest. Second, I address whether firms write contracts with these responses in mind. In other words, do contracts look like the predictions of the theory? Incentives are provided to workers

/pdf/the-provision-of-incentives-in-firms-zlx7fye09q.pdf

The Provision of Incentives in Firms

/pdf/the-theory-of-industrial-organization-19bejph0ej.pdf

The Theory of Industrial Organization

We model a firm’s demand for liquidity to develop a new test of the effect of financial constraints on corporate policies. The effect of financial constraints is captured by the firm’s propensity to save cash out of cash flows (the cash flow sensitivity of cash). We hypothesize that constrained firms should have a positive cash flow sensitivity of cash, while unconstrained firms’ cash savings should not be systematically related to cash flows. We empirically estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971 to 2000 period and find robust support for our theory. TWO IMPORTANT AREAS OF RESEARCH in corporate finance are the effects of financial constraints on firm behavior and the manner in which firms perform financial management. These two issues, although often studied separately, are fundamentally linked. As originally proposed by Keynes (1936), a major advantage of a liquid balance sheet is that it allows firms to undertake valuable projects when they arise. However, Keynes also argued that the importance of balance sheet liquidity is influenced by the extent to which firms have access to external capital markets (p. 196). If a firm has unrestricted access to external capital— that is, if a firm is financially unconstrained—there is no need to safeguard against future investment needs and corporate liquidity becomes irrelevant. In contrast, when the firm faces financing frictions, liquidity management may become a key issue for corporate policy. Despite the link between financial constraints and corporate liquidity demand, the literature that examines the effects of financial constraints on firm behavior has traditionally focused on corporate investment demand. 1 In an influential paper, Fazzari, Hubbard, and Petersen (1988) propose that when firms face financing constraints, investment spending will vary with the availability of internal funds, rather than just with the availability of positive net present

http://people.stern.nyu.edu/eofek/PhD/papers/ACW_Cashflow.pdf

The Cash Flow Sensitivity of Cash

The theory of precautionary saving is shown in this paper to be isomorphic to the Arrow-Pratt theory of risk aversion, making possible the application of a large body of knowledge about risk aversion to precautionary saving, and more generally, to the theory of optimal choice under risk In particular, a measure of the strength of precautionary saving motive analogous to the Arrow-Pratt measure of risk aversion is used to establish a number of new propositions about precautionary saving, and to give a new interpretation of the Oreze-Modigliani substitution effect

Precautionary Saving in the Small and in the Large

What are the welfare effects of enhanced dissemination of public information through the media and disclosures by market participants with high public visibility? For instance, is it always desirable to have frequent and timely publications of economic statistics by government agencies and the central bank? We examine the impact of public information in a setting where agents take actions appropriate to the underlying fundamentals, but they also have a coordination motive arising from a strategic complementarity in their actions. When the agents have no private information, greater provision of public information always increases welfare. However, when agents also have access to independent sources of information, the welfare effect of increased public disclosures is ambiguous.

/pdf/social-value-of-public-information-5fncsxwy4n.pdf

Social Value of Public Information

This paper examines how the degree of competition among firms in an industry affects the optimal incentives that firms provide to their managers. A central assumption is that there is free entry and exit in the industry, which implies that changes in the nature of competition lead to changes in the equilibrium market structure. The main result is that as the intensity of product market competition increases (as a result of greater product substitutability or greater market size), principals unambiguously provide stronger incentives to their agents to reduce costs. At the same time, more intense competition also leads to more volatile firm-level profits. Consequently, managers’ incentives are positively correlated with firm-level risk, consistent with empirical evidence. A decrease in the cost of entering the market has the opposite effect on incentives, but still induces a positive correlation between risk and incentives.

Competition, Risk and Managerial Incentives

https://sticerd.lse.ac.uk/dps/te/te260.pdf

A General Model of Information Sharing in Oligopoly

We analyze how the availability of internal funds affects a firm's investment We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions Using a large data set, we find strong empirical support for our predictions Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature

/pdf/the-u-shaped-investment-curve-theory-and-evidence-2hxal9qxwn.pdf

The U-Shaped Investment Curve: Theory and Evidence

This paper examines how the degree of competition among firms in an industry affects the optimal incentives that firms provide to their managers. A central assumption is that there is free entry and exit in the industry, which implies that changes in the nature of competition lead to changes in the equilibrium market structure. The main result is that as the intensity of product market competition increases, principals unambiguously provide stronger incentives to their agents to reduce costs, and hence agents work harder. At the same time, more intense competition also leads to a higher volatility of both firm-level profits and managers' compensation. Consequently, managers' incentives are positively correlated with firm-level risk, consistent with empirical evidence.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID262648_code010308130.pdf?abstractid=262648&mirid=1&type=2

I examine optimal incentives, performance measurement and delegation in a model where an agent has specific knowledge (in the sense of Jensen and Meckling) about the consequences of his actions for the principal. Incentive contracts can be based both on measures closely related to the agent's actions ("inputs"), and a measure closely related to the principal's payoff ("output"). While input-based pay minimizes the agent's income risk, only output-based pay encourages the agent to use his knowledge in choosing his actions. To balance these objectives, it is in general optimal to use both performance measures. The results of the analysis provide a common explanation for why central predictions of agency theory, notably predictions implied by the Informativeness Principle, are often not supported by evidence. Moreover, they lead to many novel and testable predictions about properties of incentive contracts and optimal delegation decisions.

/pdf/specific-knowledge-and-performance-measurement-5dytkmf51a.pdf

Michael Raith

Papers

Competition, Risk and Managerial Incentives

A General Model of Information Sharing in Oligopoly

The U-Shaped Investment Curve: Theory and Evidence

Competition, Risk and Managerial Incentives

Specific knowledge and performance measurement