The name of the game is to keep your employees engaged in their work and make as much money as possible. In our basic principal-agent model where you’re trying to figure out how much to pay someone for their effort, it’s been empirically proven that a 100% commission rate let’s agents make enough money to stay motivated enough to keep working and creates an opportunity for the principal maximize their profits. But it’s not that simple in the real world, and we see our model change significantly when we bring in two important assumptions:
Uncertainty and risk aversion
First, if all of your income is based entirely on output – for example, the number of sales you close in any given month – what happens if it snows one week and some of your accounts close? Now instead of having 20 full business days to close as many sales as possible you’re left with 15. Why would you be okay only earning money based on your output if you know it could snow? It probably doesn’t make sense to accept a contract that doesn’t account for outcomes caused by events out of your control unless you’re completely risk neutral.
Multiple tasks and partial observability
Second, almost all employers care about more than just your output or ability to make sales – they also want you to treat customers respectfully, be honest, do business ethically, etc. The problem is that these less tangible aspects are harder to measure and consequently, harder to include in an employment contract. Cases like this are referred to as multitask principal-agent problems. Theoretically, if you’re only paid on the number of units you sell or produce, you won’t pay as close attention to the other important aspects that matter to everybody except your paycheck. We saw this in the study on the Chinese electronics factory: workers were paid on output and not quality, and so quality slipped when workers were presented with strong financial incentive to solely produce more. It follows that it is often optimal to offer next to no commission to employees when their output is multidimensional.
What it means for you as an employee
Consider your role in the organization. What value do you bring with you to the table? How much more could you do if you were paid more based on commission? How much base pay would you be willing to give up?
If your salary is 100% base, and you’re not paid on your output, try focusing on the little things that other people don’t pay as close attention to. Companies are looking for who gives a shit and most people who earn no commission simply show up on time, do the things they’re asked, and that’s all. The point is that it’s just a job to most people. Doing the little things, especially the stuff you’re not paid for, and doing them well proves that you actually want to do good work and help the company succeed. Since it’s hard to find workers like you who are intrinsically motivated to succeed, your value to the firm increases exponentially and it becomes riskier for them to let you leave to go work somewhere else.
In short: Do the little things. Accept a little responsibility. And pull up to the negotiating table with confidence.
The following discusses the economic theories behind my belief that doing the little things can increase your earnings potential by 10x.
Principal-Agent Model
Uncertainty and Risk Aversion
The first thing employers could do is write two different contracts depending on the “state of nature” – (i.e whether it snows and you lose a couple business days or it doesn’t snow and there’s no excuse to not close sales.)
Solution
Base pay: No snow (Good ) < Snow ( Bad )
Commission rate: No snow ( Good ) = Snow ( Bad )
It turns out that if firms are risk neutral, employees are risk averse, and the contract can be explicitly indexed to the state of nature, the profit-maximizing contract sets the commision rate equal to 100% in all states, but insures workers by offering a higher base pay in worse states.
What’s normally at play in these situations though is an immeasurable factor that creates uncertainty to workers output and subsequent level of income. As such, workers take on a certain degree of risk by accepting a job that could be impacted by an external factor outside of their control. The more sensitive their output is to that factor, the more risky it is for them take the job.
SOLUTION
Base pay: Increases with higher levels of uncertainty and risk
Commission rate: Declines with higher levels of uncertainty and risk
It’s a trade off between insurance and incentive. Because workers value more predictable earnings stream when facing a lot of uncertainty and firms need to profit, it’s best to raise the amount of base pay and lower the amount of rate of variable pay.
Evidence from Sharecropping in the South
Types of contracts
- Pure wage labor ( b = 0 ): Farmers earn a fixed amount per season regardless of the amount of corn or cotton harvested. Gives no incentive to increase output but protects them from risks, such as weather, that influence crop yields.
- Share contracts ( 0 < b < 1 ): Farmers earn a share ( b ) of the crops he grows in a season. Landowner keeps whatever is not paid to the worker ( 1 – b ). Higher levels of b give the worker stronger incentive but expose him to more risk
- Rental contracts ( b = 1 ): Farmers keep 100% of the crops. Landowner simply charges a flat fee per season to rent the land. Gives farmers the greatest incentive to increase output but is also extremely risky.
Higgs asked which types of contracts were used for which crops in which locations and found two key results: As the uncertainty in production went up, fewer pure rental contracts were used, and more pure wage-labor contracts were used. Within the share contracts, farmers’ share of output went down as the uncertainty in production went up.
Multitasking and Partial Observability
Most jobs are multidimensional
Most people know who Mike Trout is. If you don’t, look him up. Trout just signed a 12-year, $426.5-million contract with the Angels, officially making him the highest paid player and unofficially the most dominant player in Major League Baseball. What’s scary is that’s just the amount of money he’s guaranteed for showing up to work on time. But the Angels aren’t just paying Trout to travel with the team and sit in the dugout like they’re paying Pujols to do. They’re paying him to get on base, drive runners in, and put points on the board – in other words, they’re paying him to win a Silver Slugger which captures all of those dimensions. When Trout gets named an AL Silver Slugger like he has seven of the last eight seasons he earns an additional $500,000 – a potential 1.5% annual bonus.
Pujols’ job is arguably more one dimensional. He’s way past his prime but as the Angels work to rebuild their lineup and win games, there’s value in having a veteran leader in the clubhouse. The Angels and Pujols both know it’s unrealistic to expect him to hit as many homeruns or bring in as many RBIs as he did when he was a Cardinal. At this point in his career, it makes more sense for his pay structure to be based less on his performance and more on his ability to set a good example for the young guys and use his experience to lead.
Incomplete incentives are bad for business
Countrywide Financial Corporation used to be a mortgage originator. In other words, they sold mortgages to the public. The company relied heavily on incentive pay for its originators – more loans meant more profits for them and more income for their employees. The problem was that their incentive pay structure depended only on the type and dollar value of loans; they didn’t care at all about whether the borrower eventually defaulted. Mortgage originators at Countrywide naturally lended the largest amounts possible to financially fit and unfit borrowers and the company became known as the place to go for people who couldn’t get anyone else to lend them money. By June 30, 2007, 25% of the subprime loans serviced by Countrywide were delinquent and one year later, Countrywide agreed to pay $8.4 billion in direct loan relief for some 400,000 mortgagers.
The company and its employees had zero interest in the mortgages long-term performance. Because the collapse in the value of low quality CDOs was what precipitated 2008’s financial collapse, employee incentive plans like Countrywide’s appear to have played a role in creating the Great Recession. Clearly, getting employees’ incentives right matters.
Designing incentive pay is not just a minor concern of HR departments: It is a central component of business strategy with implications for the long-term success of companies, and indeed the entire economy.
Peter Kuhn, UCSB
Possible Solutions to Multitask, Principal-Agent Problems
Design more complete performance measures that leave nothing out: Mike Trout wins games and he’s a great asset to drive ticket and merchandise sales. His incentive to win the Silver Slugger takes care of the first part, whereas the latter is probably more contingent upon whether he’s seen as a good dude. So, part of his contract might include fan engagement.
Reduce the strength of incentives: A salesperson with less riding on one sale is more likely to pay closer attention to the intangibles such as cultivating long-term customer relationships or the ethics behind giving a financially unsound mortgage applicant a loan that will like default.
Offer zero incentives: Find someone highly motivated to do the job well even without explicit performance incentives.
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