Incentive contracts and the firm

In this chapter our primary task has been to consider in some detail the contractual problems which face two parties when outcomes are uncertain, and when information cannot be observed or is costly to observe and subject to error. It is appropriate at this point to discuss explicitly the significance for the theory of the firm of the issues covered in the first six sections. Sharecropping, franchising, insurance contracts, police incentives, and even some of the employment contracts discussed earlier, may at first appear rather specialised and peripheral concerns rather than of central importance. Yet, as has been emphasised from the very outset, the firm is a particular type of contractual environment, and its characteristics would be expected therefore to be moulded by the sorts of considerations which formed the basis of our discussion above. In Chapter 1, the firm was ratio­nalised as a device for coping with uncertainty and the passage of time; in Chapter 2 it was seen as a response to ‘opportunistic behaviour’ resulting from ‘information asymmetry’, in Chapter 4 the firm evolved to permit policing and monitoring of cooperating inputs in conditions of ‘team pro­duction’. All these ideas are closely interrelated. They all reduce ultimately to the firm as an institutional consequence of imperfect information, and they all have in common the idea of the firm as a nexus of contracts with a central agent.

Within the nexus of contracts called the firm, however, there is scope for considerable variety. The nature of the contracts is not absolutely standard and will vary as conditions vary. As we saw in Chapter 2, Coase (1937) stressed the direction of resources and the employment or ‘authority’ rela­tion as characterising the typical contract. No doubt there are particular cases in which this is descriptively not unrealistic, but labour is not the only type of input used by the firm and, as pointed out at the end of Chapter 2, positive monitoring costs associated with less than perfect ‘observability’ (Williamson would say ‘information asymmetry’) will usually mean that employer-employee relationships have attributes similar to those of prin­cipal and agent. The sections above have indicated, however, that there are many possible ‘solutions’ to the principal-agent problem, depending on assumptions about what is and what is not observable, the risk preferences of the parties, the costs of monitoring and so forth.

In some firms, people will be closely monitored, whereas in others they may have wider discretion. Some will be paid according to their own par­ticular output (for example, by piece rates), others in ‘team’ environments (in the sense of Alchian and Demsetz) may be paid according to their effort. Payment according to effort will involve ‘monitoring gambles’ as described above, and the nature of these may also vary between firms. If monitoring of effort is very efficient and reliable, the risk involved in being monitored may be small, perhaps involving small bonuses or other prizes. Where mon­itoring is less reliable, the gamble may be substantial, as when promotion to a higher grade involves a considerable pay rise. Thus, the structure of a hierarchy can be seen as being closely related to the provision of incentives through what we have called ‘monitoring gambles’ and this is a topic which will be taken further in Chapter 6.

It is important to remember also that within a single firm different people will have different types of contract. A senior manager whose performance is difficult to monitor by shareholders may have a contract which links remu­neration to the outcome through stock options or bonuses linked to profits. Similarly, a travelling salesman for the company may depend heavily on his particular sales record, the difficulty of monitoring implying that the sales­man has to tolerate considerable risks. The professional designers of the product, on the other hand, are also difficult to monitor, but because indi­vidual ‘output’ may be impossible to measure, ‘effort’ may be monitored and incentives given by means of promotion through a hierarchy. At least a design team is likely to be concentrated in a particular geographical loca­tion, and members may thus be assessed by more senior leaders of the team. The people who actually fabricate the product could have quite different contracts again, depending on the technological context and its implications for monitoring. To take just one example, a simple production-line process involving little chance for ‘shirking’, with the line speed predetermined by the manager, could result in a standard payment per ‘shift’. Providing the number of ‘shifts’ worked per week does not vary, the employee would be relieved of all risk. For a risk-averse employee, this would be preferred to a contract dependent upon output, since output would vary with technical problems such as ‘breakdowns’ or poor components. Where, however, as is almost invariably the case in practice, the chance of a breakdown or the quality of the final product depends to some degree on the alertness, con­centration, or dexterity of the employee, incentives via the possibility of promotion may still be used even on production lines.

Where monitoring is very costly, and effort and state of the world are effectively ‘unobservable’, contracts will depend upon the outcome alone. A particular example of this arrangement is the franchise contract, and we have discussed some of its properties in an earlier section. In the present context, however, the franchise contract warrants closer inspection because it represents a relationship which leaves the franchisee with a large area of discretion as to how affairs should be conducted. It is thus far distant from the ‘authority relation’ discussed by Coase, or the exercise of ‘conscious power’ mentioned by Robertson. From the point of view of economic prin­ciple, however, a franchise chain would seem to have the major character­istic required to make it a single ‘firm’. A franchise chain is a ‘nexus of contracts’ in which each franchisee has a contract with a single contractual agent or franchisor. Legally, these contractual arrangements exist between separate ‘firms’, yet economically the transactions might be regarded as taking place within a single firm. This is the essence of a contribution by Rubin (1978, p. 225) which emphasises the somewhat arbitrary distinction between interfirm and intrafirm transactions and argues that ‘the economic concept of a “firm” does not have clear boundaries’.¹²

The theoretical developments reported in this chapter are in the neo­classical ‘contracts’ tradition. There are several features of firms which need to be borne in mind when interpreting the results.

1. Firms will usually be contracting with several agents (whether workers or suppliers) and if all agents face similar environmental conditions (even if these are not observable by the principal) relative performance may be used to assess an agent’s effort. Providing the agents do not con­spire against the principal, information on relative performance can be used in contracting. The firm, in other words, runs a tournament. Further analysis of the tournament as an incentive device is provided in Chapter 6.
2. In a market setting, repeat dealing may be important. Similarly, within a firm contracts continue over time and are not isolated events. This means that information on an agent’s past performance can be used in future contracts. Shirking can result in a process of settling up ex post, and agents will have to consider the implications of a poor outcome for the terms of future agreements.
3. If agents differ from one another in their level of skill, the problem of choosing the agent and adapting the contract to his or her particular attributes becomes important. In the case of risk-neutral agents, the choice might be made by auctioning a contract to the highest bidder. Some of the contractual difficulties with this approach are considered in Chapters 11 and 15 in the context of the contracting-out of govern­ment services. If competitive bidding is not suitable, screening devices may, in some circumstances, be used to separate agents of differing quality. Chapter 6 explains the principles of screening mechanisms in more detail.
4. The agency contracts investigated in the earlier sections of this chapter were complete. Because there were only two possible outcomes, two possible effort levels, and a single period of time, the contract could be specified relatively simply. Contracts within the firm, as emphasised in earlier chapters, are incompletely specified as a result of bounded ratio­nality. In this respect, principal-agent theory does not take into account one of the major elements of the nexus of contracts concep­tion of the firm.

Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.