An economist explains the work of this year’s winners of the Nobel Prize in economics

From left: Tomas Sjoestroem, a member of the Nobel Economics Prize committee; Goran K Hansson, the secretary general of the Royal Swedish Academy of Sciences; and Per Stroemberg, the chairman of the NShow more

The two men who on Monday received the 2016 Nobel prize in economics, Oliver Hart and Bengt Holmstrom, made key contributions to contract theory, including the “principal-agent” (PA) model.

The PA model is a general tool for analysing a situation where one person, the principal, wants to pay another person, the agent, to perform a task, and where the agent can hide information from the principal, such as how hard the agent is working and how well qualified the agent is to perform the task in the first place.

Regular people can often be heard demanding that others be subject to performance pay, especially in the case of players for their favourite sports teams. The PA model helps us to understand the intermittent absence of performance pay by referring to the incentives-insurance tradeoff.

Suppose a manager hires a worker to sell cars in a situation where only the worker can see how hard the worker is working; the manager can see only how many cars get sold. If the manager pays a flat wage, then the worker will have no incentive to exert any effort, and no cars will be sold.

In that case, the manager will want to make the contract completely performance pay, also known as commission compensation, ensuring that the worker is well motivated.

Now suppose that how many cars get sold depends on two things: the worker’s effort, still known only to the worker; and the general demand for cars in the market, which neither the manager nor worker is completely sure of.

Will the manager still opt for pure commission compensation? Doing so makes the contract risky for the worker, because if general demand happens to be low, then working hard could end up yielding little. The manager cannot naively accept the worker saying: “I worked hard, but demand was low,” otherwise the worker could simply start lying. Thus, the worker’s earnings will have ups and downs due to factors outside the worker’s control. People dislike risk, and if the worker is forced to have a risky wage, then he will demand a higher average rate of compensation to stick with the job over a stable alternative.

That makes the risky contract more expensive for the manager, hurting the manager’s bottom line.

One way to lower the wage bill is to offer some flat compensation in exchange for lowering the commission pay; for example, Dh1,000 per month plus 2 per cent of all sales, rather than 3 per cent of all sales. The less risky the overall compensation, the more desirable it is to the worker, and hence the lower the average rate necessary to keep the worker from leaving the job.

The downside is that the worker has less of an incentive to work hard. Thus, the manager has to trade off the desire to give the worker an incentive to work hard, against the desire to shield (insure) the worker from risk so that the average wage can be lower; hence the incentives-insurance tradeoff.

What makes the manager place more weight on incentives rather than insurance? When effort is the main determinant of output, such as is the cawe with a bricklayer.

In contrast, when worker effort has a lesser role, then flat pay is much more common; which is one of the reasons why your favorite football player mostly receives fixed pay, along with relatively minor performance bonuses—many factors outside a player’s control affect the player’s success, such as injuries, the performance of teammates, the opposition, the referee, and so on.

Remember that the PA problem disappears when effort can be easily observed by the principal, such as is the case with a delivery person. In that case, we again expect performance pay.

What makes the manager place more weight on incentives rather than insurance? When effort is the main determinant of output, such as a bricklayer.

For further reference, see Marginal Revolution University: Moral Hazard

Omar Al Ubaydli is programme director for international and geo­political studies at the Bahrain Center for Strategic, International and Energy Studies , and an affiliated associate professor of economics at George Mason University in the US

Follow The National's Business section on Twitter