Optimal Incentive Scheme Research Articles

Mathematical modeling of China's State-owned Enterprises' Contract System

The Chinese government has adopted a policy to separate the management and ownership of the state-owned enterprises as a key step to move them towards modern-type enterprises. State-owned Enterprises' Contract System (SECS) is a major enterprise management system in China today. In this paper, mathematical models are employed to examine some macro aspects of SECS. First, the behavior of SECS is analyzed through introducing two measurement indices; second, two incentive models of SECS are developed using audit as a tool for acquiring information for decision making; third, from a mathematical analysis, a general rule which determines optimal incentive strategy under perfect information is presented.

When to fire bad managers: the role of collusion between management and board of directors

We develop a model in which a shareholder hires a director to monitor a manager who faces stochastic firing costs. We study the optimal incentive scheme for the director, allowing for the possibility that the manager bribes the director in order to change his firing intentions. Such collusion may be in the interest of the shareholder, because it avoids the need to (ex ante) compensate the manager for very high realisations of his firing costs (these are precisely the cases in which collusion occurs).

Imprecise Beliefs in a Principal Agent Model

This paper presents a principal-agent model where the agent has multiple, or imprecise, beliefs. We model this situation formally by assuming the agent's preferences are incomplete. One can interpret this multiplicity as an agent's limited knowledge of the surrounding environment. In this setting, incentives need to be robust to the agent's different beliefs. We study whether robustness implies simplicity. Under mild conditions, we show the unique optimal contract has a two-wage structure; a flat payment and bonus. That is, all output levels are divided into two groups, and the optimal incentive scheme pays the same amount for all output levels in each group. We also show that a two-state two-action framework can be thought of as a reduced form of the original model. We solve explicitly the principal's problem in this case, and discuss some implications of our model for firm ownership.

Optimal Compensation for Fund Managers of Uncertain Type: Informational Advantages of Bonus Schemes

Performance-sensitivity of compensation schemes for portfolio managers is well explained by classic principal-agent theory as a device to provide incentives for managers to exert effort or bear the cost of acquiring information. However, the majority of compensation packages observed in reality display in addition a fair amount of convexity in the form of performance-related bonus schemes. While convex contracts may be explained by principal-agent theory in some rather specific situations, they have been criticized, both by the financial press as well as the academic literature, on thegrounds that they may lead to excessive risk-taking. In this paper, we show that convex compensation packages, though likely to be myopically not optimal, may serve as adevice to extract information about the ex-ante uncertain type of portfolio managers.Optimal contracts are thus determined by the trade-off between maximizing short-runexpected returns on one hand, and long-run informational benefits on the other. Ina discrete-time model, combining dynamic principal-agent theory with the theory oflearning by experimentation, we characterize optimal incentive schemes and optimal retention rules for fund managers, consistent with empirical observations.

Linear Contracts and the Double Moral-Hazard

This paper studies the characteristics of optimal contracts when the agent is risk-averse in the double moral-hazard situation in which the principal also participates in the production process. It is already known that a simple linear contract is one of many optimal contracts under the double moral-hazard when the agent is risk-neutral. We find that the agent's optimal incentive scheme in this case is unique and non-linear, but less sensitive to output than would be designed under a single moral-hazard. We also find that the linear contract is not robust in the sense that the above unique and non-linear contract does not approach the linear contract as the agent's risk-aversion approaches zero.Journal of Economic LiteratureClassification Number: D82.

Incentives design under parametric uncertainty

This paper investigates incentives design problems where the leader lacks precise knowledge on a certain parameter, which describes the problem situation, but the leader can collect information from the follower. We first illustrate that the follower may misrepresent information when the leader's strategy depends on information provided by the follower. To deal with incentives design problems in such a situation, two ideas are proposed. One idea suggests using a misrepresentation-proof optimal incentive strategy (MOIS), which can induce the follower to report true information and simultaneously to take actions in favor of the leader's interest; while the other idea suggests imposing threat to enforce the follower to reveal truth through using a mixed investigation strategy. Furthermore, in the first case we get two kinds of existence conditions of MOIS and two constructing methods for it, while in the second case we examine the mixed investigation strategies which can prevent the follower from misrepresentation, and then evaluate them from the leader's interests.

Efficiency Wages and X-Inefficiencies

Within most organizations, agents may spend time on a variety of tasks, productive and redistributive. In this paper, I derive an optimal multi-task incentive scheme under the realistic assumption that agents have limited liability. The wage level is shown to increase with an agent's discretion and the organization's profits. With multiple agents, it is generally not optimal for the principal to fully eliminate distributional conflict within the organization. The resulting influence costs constitute a measure of X-inefficiency. The paper illuminates the relationship between competition and influence costs, emphasizing the role of the organization's production technology.

Incentive Contracts in Two-Sided Moral Hazards with Multiple Agents

The paper studies a contracting problem in which a principal enters in two-sided moral hazards withNindependent agents. There are no technological or informational linkages among theNagency problems. Despite this independence, optimal incentive schemes essentially eliminate the principal's incentive problem when team size is large enough. Reputation-like effects appear in a static setting through an improved aggregation of information about the actions of the principal. One implication of this result is that it is generally suboptimal to require an agent's compensation to depend only on his own outcome. Another implication is the existence of purely informational economies of scale to increasing team size. Thus, the concentration of otherwise unrelated transactions in a single “firm” creates wealth through a more efficient use of information about the Principal's actions. The paper also shows that extremely simple statistical contracts are approximately optimal in large teams. The outcome of such contracts is observationally indistinguishable from standard principal–agent contracts. This provides a theoretical justification for using standard principal–agent contracts in environments that involve two-sided hazard in a fundamental way.Journal of Economic LiteratureClassification Numbers: D21, D23.

Peer Pressure in an Agency Relationship

We investigate the role of peer pressure in influencing the optimal incentive scheme offered to workers engaged in team production. We develop an agency model of peer policing to identify factors that affect the extent of mutual monitoring. As the principal must compensate workers for their monitoring efforts and the costs that peer pressure imposes on workers, introducing peer pressure alters the optimal compensation package. We establish conditions under which the principal reduces the marginal compensation rule to reduce monitoring efforts. As such, peer pressure provides a rationale for a reduced link between compensation and output in a team setting.

On misrepresentation-proof strategies in incentive design problems

This paper investigates incentive design problems in hierarchical systems where the leader relies on information provided by the follower and the follower may have motivation to misrepresent information. To deal with incentive design problems in such a situation, the notion of misrepresentation-proof optimal incentive strategy (MOIS) is proposed, which induces the follower to report true information to the leader and simultaneously to take actions in favour of the leader's interest. Existence conditions of MOIS are then obtained and two construction methods for such strategies are suggested.

Optimal Incentive Schemes when Only the Agents' "Best" Output Matters to the Principal

Standard principal-agent models assume that the principal's payoff is a function of the total output of all agents. In many real-world situations, however, the principal's payoff is based solely on the best of the agents' outputs (e.g., the first agent to make an innovation, the most creative advertising campaign, or the cheapest product design). The results obtained from such a model differ from the standard results in a number of respects. For instance, even when identical agents perform identical tasks, the optimal incentive scheme will often differ across agents. Also, the principal may want to increase the variance of the agents' output or reduce the correlation of output across agents, even when the agents are risk averse.

Recent Central-Bank Reforms and the Role of Price Stability as the Sole Objective of Monetary Policy

Recent and prospective central banking reforms represent attempts to develop institutional solutions for the inflation bias that can arise under discretionary monetary policy. An alternative to mandated objectives or targeting requirements is offered by proposals to develop incentive contracts that base the central bank's rewards (or penalties) solely on the realized rate of inflation. Deriving optimal incentive schemes provides a normative benchmark against which central bank institutions can be compared. New Zealand's policy structure most resembles a performance contract; it has well-defined procedures for setting short-run targets and a system to ensure accountability. As yet, however, this system has not really been tested. In Europe, the emphasis has been on political independence. Less attention has been given to ensuring that the correct incentives for making short-run policy tradeoffs are established, nor has sufficient attention been placed on ensuring accountability.

Recent Central-Bank Reforms and the Role of Price Stability as the Sole Objective of Monetary Policy

Recent and prospective central banking reforms represent attempts to develop institutional solutions for the inflation bias that can arise under discretionary monetary policy. An alternative to mandated objectives or targeting requirements is offered by proposals to develop incentive contracts that base the central bank's rewards (or penalties) solely on the realized rate of inflation. Deriving optimal incentive schemes provides a normative benchmark against which central bank institutions can be compared. New Zealand's policy structure most resembles a performance contract; it has well-defined procedures for setting short-run targets and a system to ensure accountability. As yet, however, this system has not really been tested. In Europe, the emphasis has been on political independence. Less attention has been given to ensuring that the correct incentives for making short-run policy tradeoffs are established, nor has sufficient attention been placed on ensuring accountability.

Incentive Efficient Production Frontiers: An Agency Perspective on DEA

In this paper, we examine how empirical production frontiers may contribute to the incentives of production units. We consider a series of Data Envelopment Analysis (DEA) frontiers, and we show when these may be incentive efficient in the sense that they contain all the information that are relevant for optimal incentive provision. The frontiers considered include the so-called constant, decreasing and varying return to scale models, the free disposability and the free replicability models, as well as the increasing and decreasing return to scale models based on a relaxed set of assumptions. Also, we illustrate how to design optimal incentive schemes based on such frontiers. Contents: 1. Introduction, 2. The Incentive Problem, 3. Production Frontiers and Productivity Measures, 4. Incentive Efficient Production Frontiers, 5. Extensions, 6. An Example, 7. Final Remarks, Mathematical Appendix, References.

An incentive-based theory of bank regulation

In this paper we analyze how depositors can employ both monitoring and capital requirements to control the risk of bank assets. We also analyze how monitors should be compensated if their actions are not directly observable and if there are binding limits on their liability. Second-best capital and monitoring levels (with unobservable actions) will be distorted away from their respective first-best levels. We derive some results about the nature of these distortions and characterize the optimal incentive scheme for monitors.

Optimal incentive strategy for leader-follower games

An optimal incentive strategy by which the leader suffers the least losses in punishing the follower's deviation from the decision desired by the leader is defined. Sufficient conditions for the existence of optimal incentive strategy are given. Static and dynamic leader-follower games with quadratic cost functionals are investigated. It is shown that leader-follower games with quadratic cost functionals admit optimal incentive strategies under the follower's decision variable being scalar, there exists a unique linear optimal incentive strategy. Such an incentive strategy can be explicitly determined. >

Monetary Rules as Optimal Incentive Strategies

In a Stackelberg Incentive Model, a monetary rule in the form of an incentive function is derived as an optimal strategy. A Stackelberg Incentive Equilibrium is solved for the widely used Barro-Gordon unemployment-inflation game. A dynamic version of the model is also considered. An equ ilibrium incentive strategy (a monetary rule) that leads to a team optimal solution of zero expected inflation and zero actual inflation is obtained. Providing a formal game equilibrium foundation for monetary rules may: (i)remove the policymaker's incentive t o deviate from the rule, and(ii)incite private agents to perceive monetary rules as credible policies.

Economic Organizations as Games.

Part 1 Equilibrium theory: the existence of equilibrium in discontinuous economic games - theory, application, P.Dasgupta and E.Maskin. Part 2 Imperfect competition: on the rate of convergence of oligopoly equilibria in large markets - an example, P.Dasgupta and Y.Ushio natural oligopolies, A.Shaked and J.Sutton relaxing price competition through product differentiation, A.Shaked and J.Sutton the theory of technological competition, P.Dasgupta strategic considerations in invention and innovation - the case of natural resources, P.Dasgupta, R.Gilbert and J.E.Stiglitz. Part 3 The design of organisations: on the revelation principle under complete and incomplete information, R.Repullo optimal incentive schemes with many agents, D.Mookherjee.

An optimal incentive scheme for planning with targets

In socialist economies incentive schemes that contain targets are useful to planners since planners must allocate output to various users. We use a principal-agent model to show that under certain circumstances a first-best Pareto-optimal incentive scheme containing a target exists.

On the design of incentive schemes under moral hazard and adverse selection

This paper characterizes a class of optimal incentive schemes in a simple principal–agent model which allows for moral hazard and adverse selection. We show that incentive compatible allocation can always be (approximately) implemented through a menu of quadratic incentive schemes. It is also proved that the set of incentive compatible allocations is independent of the distribution of the additive uncertainty which affects the outcome. Informational requirements and economic interpretation of quadratic and linear schemes are discussed.