management. lecture 6. Subjectivity.

performance measures are useful to address agency problems but problems are:

• noise problem

• congruence problem / bias

noise problem

performance measure can be influenced by uncontrollable factors

for who does the noise problem carry risk

the agent

congruence problem / bias

performance measure does not capture all aspects of what a good employee should do

for who does the congruence problem carry risk

principal

how to deal with noise problems

subjective performance evaluation with noncontractible information.

agency relationship

1. effort of the agent is unobservable. (true value)

2. risk averse agents combined with a noisy signal x of the agent's effort

3. the signal x can be influenced by uncontrollable factors (noise) and can be manipulated by the agent (bias)

fundamental equation of every performance measure

observed value of the PM = True value + noise + bias

what is true value linked to?

effort level a

what is Noise linked to

precision

what is Bias linked to?

congruence. manipulatin the measure

how to correct for weakly congruent performance measures and the influence of noise and bias on the observed value of a performance measure

• solution strategy 1: adapt other elements of the stool to correct for the imperfectness of the performance measure.

• solution strategy 2: introduce subjectivity

solution stratefgy 1: adapt other elements of the stool to correct for the imperfectness of the performance measure.

• adapt the delegation of decision rights so that the agent has less opportunities to bias the performance measure.

• focus on improving your reporting system to correct for noise.

• only use imperfect performance measures when they fit with the soft controls.

subjective performance evaluation

using noncontractible information that arises during the measurement period asses actions and efforts that are insufficiently captures by objective PM

solution strategy 2: use subjectivity

• indicate that you (as a principal) will use other observations to correct for the weakly congruent and/or noisy PM. inform the agent about this on beforehand to ensure sufficient verifiability.

• collect information to try to find out which noise compenents could have influenced the observed value of the performance measure

• collect information about potential sources of bias

• use the observations and collected

why do we not include in the contract how we will deal with 'noise factors'

• a lot of the 'noise factors' are unforeseen and unpredictable.

• contracting costs: it would be very difficult to try to predict all noise and write contractual clauses for it.

why do we not include in the contract how we will deal with 'congruence facors'?

• if people know what you will look for, they could start to fake it.

• contracting costs: congruent behavior manifests itself in many different ways and it would take a lot of time to describe this

different types of subjective performance evaluation

• discretionary bonus (there is formula but bonus can be adjusted in post)

• subjective weights (no formula)

why is it a good idea to include (mainly nonfinancial) performance measures?

informativeness principle

the informativeness principle

compensation contracts should include any costless measure that carries incremental information on the agent's actions. From the moment a performance measure provides additional information that is not captured by other performance measures, this performance measures should then be included in the formula based bonus contract.

what is subjectivity in compensation contracting used for?

to imporove congruence-,noise-, and bias-related problems that are intrinsically linked to the use of performance measures

when does subjectivity increase several outcomes and which

performance and satisfaction, but only when it is applied in a trusting environment.

disadvantages of subjective performance evaluation

• you open the door for favoritism, supervisor biases, and influence activities.

• the appropriate information needs to be collected: takes time or money.

when not to use subjectivity

in 'easy' environments and environments with behavioral controls

the biases in subjective performance evaluation

• leniency bias

• centrality bias

leniency bias

supervisors are reluctant to give low ratings

centrality bias

supervisors give medium ratings a lot more.

individual approach

you supervisor observes the available performance measures, collects additional information and makes the adjustment if he considers that reasonable.

problems with individual approach towards subjectivity

• performance evaluation not a better reflection of the employee's effort because collecting additional information is costly.

• centrality bias and leniency bias.

• inconsistency: different supvisors have different criteria.

• flexible teams: employees often work for different supervisors.

collective approach towards subjectivity

calibration committee. collection of supervisors.

disadvantage of calibration committee

• increase the centrality bias

• time to prepare and attend calibration committee

advantage of calibration committee

• more consistency across supervisors

• lower leniency bias.

• supervisor learning about performance evaluation.

• supervisors collect more information

what is subjectivity used to address

noise and congruence problems that drive the observed value of a performance measure.

what is a crucial component to make subjectivity work?

trust

the forms that subjectivity in performance evaluation arises in

• subjectivity as an ‘add-on’ to an objective performance evaluation:option to ex-post override a formula-based contract.

• subjectivity as an ‘integral component’ of the performance evaluation: no formula but performance measure are agreed on beforehand.

subjective performance evaluation can be based on

• other objective performance measures

• subjective performance measures that can be quantified

• personal observations of the one/team who is doing the subjective performance evaluation

• combinations of the above

reason for the agent to use subjectivity

using subjectivity to address noise factors

reasons for the principal to use subjectivity

to address congruence factors