Incentives &
Control
Summary of the Lectures
- Semester 1, Blok 1 2021-2022
,Contents
Chapter 1. Introduction into Economic Models......................................................................................3
1.1 Course...........................................................................................................................................3
1.1.1 Example Sales Representative...............................................................................................3
1.2 Scope of Inventives and Control...................................................................................................4
1.3 Why do these problems emerge...................................................................................................5
1.4 Framework of Merchant & Van der Stede....................................................................................7
1.5 Action Controls...........................................................................................................................10
1.6 Personnel Controls and Cultural Controls...................................................................................10
1.7 Incentive and Control problems at corporate level....................................................................11
1.8 Evaluation of incentive and control systems..............................................................................12
1.9 Contingency Theory....................................................................................................................13
1.10 Complementarities...................................................................................................................13
Chapter 2. Performance Measures.......................................................................................................14
2.1 Performance Measures..............................................................................................................14
2.1.1 Financial Performance Measures.........................................................................................14
Chapter 3. Nonfinancial performance measures..................................................................................16
3.1 Why Non-Financial Performance Measures...............................................................................16
3.2 Subjectivity.................................................................................................................................17
3.3 Transfer pricing...........................................................................................................................18
3.3.1 Methods..............................................................................................................................18
Chapter 4. Incentives & Target-setting.................................................................................................19
4.1 Target setting..............................................................................................................................19
4.2 Relative performance evaluation................................................................................................20
4.3 Incentives....................................................................................................................................21
Chapter 5. Equity Incentives & Corporate Governance........................................................................24
5.1 Equity Incentives.........................................................................................................................24
5.1.1 Dodd-Frank Act....................................................................................................................24
5.1.2 Stock Market........................................................................................................................24
5.2 Dismissal, Promotions & Group-based incentives......................................................................24
5.2.1 Dismissal..............................................................................................................................24
5.2.2 Promotions..........................................................................................................................25
5.2.3 Group-based incentives.......................................................................................................26
5.3 Corporate Governance...............................................................................................................26
5.3.1 Internal Governance Mechanism.........................................................................................26
, 5.3.2 External Governance Mechanism........................................................................................27
Chapter 6. The finals.............................................................................................................................29
6.1 Shareholder Activism..................................................................................................................29
6.2 Alternative Theories...................................................................................................................30
6.3 Intrinsic vs Extrinsic incentives...................................................................................................31
6.4 Technology & Future of Finance.................................................................................................31
,Chapter 1. Introduction into Economic Models
1.1 Course
Around 65-80% pass this course. It is important to answer in a complete manner. The questions are
often very specific, which means it requires a specific answer. Exam answers also have a word limit.
Be complete and straight to the point.
HBS Case, answer in a group with 4 to 5 students. Grading for these assignments: “Grading on the
curve”.
1.1.1 Example Sales Representative
Let’s say you are a sales representative with a choice of two compensation contracts, which one
would you prefer over the other?
1. Fixed Compensation of 200.000 EUR, or
2. Fixed Compensation of 100.000 EUR + Possible bonus of 200.000 EUR. (50% chance to
achieve the bonus)
Here comes the two basic assumptions of economic models, where first is Greed (Prefer more over
less). In this case it would be the second compensation contract. This means you have a very high risk
appetite. However, most people are risk averse, which means compensation contract 1.
For example, the more money you receive, the more happier you are. Happiness is the utility.
However, the increase of happiness decreases the more money you earn. In our example, we like the
fact that 300k is more than 200k. However, the dislike the 200k to 100k more than the increase from
200k to 300k. In this case people would be risk averse.
3
, The second basic assumption of economic model is information asymmetry. This means that people
have private information. This means someone could have a information advantage over other
people. We got three models, which will be explained below.
It is important to know that there is a problem, but everyone wants transactions. Who comes first
and who solves the problem? If an uninformed party moves first, this means the party without the
private information.
1. Moral Hazard
Hidden Action/Effort + Uninformed Party Moves First
Agent has private information about effort choices. It could be that the Agent prefer leisure
activities over productive (and costly) effort. How could a principal solve this problem. An
employee has its private time, which the Principal can not know. Uninformed party will move
first, which means the principal (employer) with a contract with a performance measure. He
or she can come up with performance efforts and tie a bonus to it so you work hard(er).
Example: Incentive Compensation Contracts.
2. Screening
Hidden Characteristics + Uninformed Party Moves First
Agent has private information about characteristics. This means this person knows how good
or bad he/she is but the employer does not know. For example, this person is bad in this job
as sales representative. He/she would like to have a large fixed pay and a small variable pay
because if you are bad being a sales representative you won’t make a lot of sales. If you are
good in the job, you would prefer a larger variable pay because you will make a lot of sales.
This means a contract can be designed to attract the right person. A person with less skill will
look for a different job with a large fixed pay.
Example: Contracts with large variable pay.
3. Signaling
Hidden Characteristics + Informed Party Moves First
This time the informed party moves first. A potential problem is that someone uses the
copy-paste strategy and copies what you say. The strategy only works for the high-quality
person because it is too costly.
A way to stand out is the Master program, low educated people will have trouble, because
they may not be able to pass a master program, this means the Msc degree is a credible way
of communication about ability.
1.2 Scope of Inventives and Control
Many organizations are characterized by:
1. Asymmetric information (Some members have informational advantage)
2. Some people have personal objectives that are not perfectly aligned with corporate
objectives.
4
Control
Summary of the Lectures
- Semester 1, Blok 1 2021-2022
,Contents
Chapter 1. Introduction into Economic Models......................................................................................3
1.1 Course...........................................................................................................................................3
1.1.1 Example Sales Representative...............................................................................................3
1.2 Scope of Inventives and Control...................................................................................................4
1.3 Why do these problems emerge...................................................................................................5
1.4 Framework of Merchant & Van der Stede....................................................................................7
1.5 Action Controls...........................................................................................................................10
1.6 Personnel Controls and Cultural Controls...................................................................................10
1.7 Incentive and Control problems at corporate level....................................................................11
1.8 Evaluation of incentive and control systems..............................................................................12
1.9 Contingency Theory....................................................................................................................13
1.10 Complementarities...................................................................................................................13
Chapter 2. Performance Measures.......................................................................................................14
2.1 Performance Measures..............................................................................................................14
2.1.1 Financial Performance Measures.........................................................................................14
Chapter 3. Nonfinancial performance measures..................................................................................16
3.1 Why Non-Financial Performance Measures...............................................................................16
3.2 Subjectivity.................................................................................................................................17
3.3 Transfer pricing...........................................................................................................................18
3.3.1 Methods..............................................................................................................................18
Chapter 4. Incentives & Target-setting.................................................................................................19
4.1 Target setting..............................................................................................................................19
4.2 Relative performance evaluation................................................................................................20
4.3 Incentives....................................................................................................................................21
Chapter 5. Equity Incentives & Corporate Governance........................................................................24
5.1 Equity Incentives.........................................................................................................................24
5.1.1 Dodd-Frank Act....................................................................................................................24
5.1.2 Stock Market........................................................................................................................24
5.2 Dismissal, Promotions & Group-based incentives......................................................................24
5.2.1 Dismissal..............................................................................................................................24
5.2.2 Promotions..........................................................................................................................25
5.2.3 Group-based incentives.......................................................................................................26
5.3 Corporate Governance...............................................................................................................26
5.3.1 Internal Governance Mechanism.........................................................................................26
, 5.3.2 External Governance Mechanism........................................................................................27
Chapter 6. The finals.............................................................................................................................29
6.1 Shareholder Activism..................................................................................................................29
6.2 Alternative Theories...................................................................................................................30
6.3 Intrinsic vs Extrinsic incentives...................................................................................................31
6.4 Technology & Future of Finance.................................................................................................31
,Chapter 1. Introduction into Economic Models
1.1 Course
Around 65-80% pass this course. It is important to answer in a complete manner. The questions are
often very specific, which means it requires a specific answer. Exam answers also have a word limit.
Be complete and straight to the point.
HBS Case, answer in a group with 4 to 5 students. Grading for these assignments: “Grading on the
curve”.
1.1.1 Example Sales Representative
Let’s say you are a sales representative with a choice of two compensation contracts, which one
would you prefer over the other?
1. Fixed Compensation of 200.000 EUR, or
2. Fixed Compensation of 100.000 EUR + Possible bonus of 200.000 EUR. (50% chance to
achieve the bonus)
Here comes the two basic assumptions of economic models, where first is Greed (Prefer more over
less). In this case it would be the second compensation contract. This means you have a very high risk
appetite. However, most people are risk averse, which means compensation contract 1.
For example, the more money you receive, the more happier you are. Happiness is the utility.
However, the increase of happiness decreases the more money you earn. In our example, we like the
fact that 300k is more than 200k. However, the dislike the 200k to 100k more than the increase from
200k to 300k. In this case people would be risk averse.
3
, The second basic assumption of economic model is information asymmetry. This means that people
have private information. This means someone could have a information advantage over other
people. We got three models, which will be explained below.
It is important to know that there is a problem, but everyone wants transactions. Who comes first
and who solves the problem? If an uninformed party moves first, this means the party without the
private information.
1. Moral Hazard
Hidden Action/Effort + Uninformed Party Moves First
Agent has private information about effort choices. It could be that the Agent prefer leisure
activities over productive (and costly) effort. How could a principal solve this problem. An
employee has its private time, which the Principal can not know. Uninformed party will move
first, which means the principal (employer) with a contract with a performance measure. He
or she can come up with performance efforts and tie a bonus to it so you work hard(er).
Example: Incentive Compensation Contracts.
2. Screening
Hidden Characteristics + Uninformed Party Moves First
Agent has private information about characteristics. This means this person knows how good
or bad he/she is but the employer does not know. For example, this person is bad in this job
as sales representative. He/she would like to have a large fixed pay and a small variable pay
because if you are bad being a sales representative you won’t make a lot of sales. If you are
good in the job, you would prefer a larger variable pay because you will make a lot of sales.
This means a contract can be designed to attract the right person. A person with less skill will
look for a different job with a large fixed pay.
Example: Contracts with large variable pay.
3. Signaling
Hidden Characteristics + Informed Party Moves First
This time the informed party moves first. A potential problem is that someone uses the
copy-paste strategy and copies what you say. The strategy only works for the high-quality
person because it is too costly.
A way to stand out is the Master program, low educated people will have trouble, because
they may not be able to pass a master program, this means the Msc degree is a credible way
of communication about ability.
1.2 Scope of Inventives and Control
Many organizations are characterized by:
1. Asymmetric information (Some members have informational advantage)
2. Some people have personal objectives that are not perfectly aligned with corporate
objectives.
4
