Popularity of Incentive Contracts

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1. The incentive contracts are becoming more popular. Why? Evaluate of the objective incentive scheme is needed.

Most incentive contracts are based on measures other than the total value of the organization. A performance measure's usefulness in an incentive contract will depend on its distortion and risk: the more distorted and the riskier the measure, the less valuable it will be to the organization and the less it will be used in an incentive contract. Furthermore, organizations rarely have available low risk, low distortion measures, and so are generally making trade-offs between measures that are high risk and low Baker -21-distortion, or low risk and high distortion.

Baker, George. 1992. "Incentive Contracts and Performance Measurement," Journal of Political Economy 100(3):598-614.

When one party (the agent) has more information than another (the principal), but the principal has some imperfect measure of an agent's effort, it is possible to write an incentive contract to motivate good behavior. Incentive contracts involve paying agents a "bonus" on the basis of a good measured outcome and punishing them otherwise. To work the difference between their payoff in the good and bad outcomes must satisfy an incentive compatibility constraint (i.e., be self-enforcing). However, the whole package must be sufficiently attractive (i.e., it must satisfy the agent's participation constraint). There are two main costs associated with giving "objective" incentive contracts: (1) if agents are risk averse, then, in order participate, they must be compensated for the necessary risk they must bear when being given incentives; (2) if objective measures are imperfect or subject to manipulation, they may encourage undesirable actions. As such, gaming or distortions may arise if you attempt to shield agents from variables they have no direct control over; or alternatively, too much motivation for one task at the expense of another may occur. In managing incentive contracts, it is critical that commitments are made. If things like the ratchet effect are anticipated, the value of the incentive contract can be undermined.

Milgrom, P. and J. Roberts [1992] 'Economics, Organization and Management', (En-glewood Cli®s NJ: Prentice Hall)

http://www.mbs.edu/home/jgans/incentives/materials/Examdet-Final-2005.pdf#search='define%20incentive%20contracts'

This is the accessible text file for GAO report number GAO-02-661 entitled 'Welfare Reform: Federal Oversight of State and Local Contracting Can be Strengthened' which was released on June 11, 2002. (Below)

Under incentive contracts, the amount paid to contractors is determined based on the extent to which contractors successfully achieve specified program objectives for TANF recipients, such as job placements and the retention of jobs. Cost-reimbursement plus incentive contracts pay contractors for costs they incur and provide payments above costs for the achievement of specific objectives.

"...incentive contracts became more popular despite the concern of influential Congressman Carl Vinson, who saw that one of the major problems with the incentive contract form was that it motivated a contractor to inflate initial cost estimates."
VI FASHIONS IN GOVERNMENT PROCUREMENT http://www.generalatomic.com/jetmakers/chapter6.html
"The advantages to government of the incentive method are that it will attract more potential contractors because risks are shared with government and the contractor's risks are lower. Therefore, there is potential for more bidders and for lower bids. A major disadvantage of incentive contracts is that the government must have a reliable means of assessing and auditing the contractor's costs." Valuing and pricing forests, forest fees and revenue collection - http://www.fao.org/DOCREP/005/Y1398E/y1398e08.htm

This finding is confirmed in a new empirical study (Moriones et al 2004), which finds that firms using deferred compensation to a smaller extent than other firms are using short-term bonuses as an incentive mechanism.

Bayo-Moriones, A., Galdon-Sanchez, J.E., and M. Guell (2004), "Is Seniority-
Based Pay Used as a Motivation Device? Evidence from Plant Level Data". IZA Discussion Paper no 1321.
(Below) This article discusses the influence of how information management alters the standard incentive contracts. It concentrates on the use of incentive contracts as a tool to entice their employees in information acquisition via using a principal and an agent.
Lewis, R. T., & Sappington M.E. D (1997 August). Information management in incentive problems. The Journal of Political Economy, 105 (4) 796-821. Retrieved April 23, 2001 from the World Wide Web: http://www.jstor.org ...