In this lecture, Holmstrom critiques In this lecture, Holmstrom critically evaluates the performance incentive system and concludes that pay for performance is not easy to implement implemented. Additionally, it is best suited for industries and jobs where success can be easily quantified, such as sales and production industries. Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”? Get the original essayPay for performance is also linked to market integration within the company. This means that the company's employees are competitors and will fight among themselves to get the most out of the company's limited resources. Holmstrom defends this model and writes in his article, based on his 25 years of experience with incentive problems, that within companies, large-scale financial incentives can be very dysfunctional and that attempts to bring the market inside the company are generally unwise. As a general rule, it is best to avoid very powerful incentives and sometimes not to use performance pay at all. The Principal Agent ProblemThe principal-agent problem is one reason why pay for performance is complicated. Typically, you set the principal as the employer and the agent as the employee. For example, if you retain the services of a lawyer, then you will be the principal and the lawyer will be the agent. Most of the time, the principal and the agent have different motivations. Contracts can be difficult because their preferences are not aligned and agents' performance is imperfectly measured. If the principal cannot perfectly measure the agent's performance, then paying for performance will induce risk on the agent and since the agent wants to avoid risk as much as possible, there is a trade-off between risk and l 'incentive. Generally, this problem is solved by introducing linear performance bonus in addition to the fixed salary. But the problem with using a linear function is that the answer won't tell us why different incentives are used in different contexts. Moreover, it does not tell us about the trade-offs that cause incentive problems. When designing a contract between the principal and the agent, there are two constraints. The first is that the agent should get at least his reservation utility if he chooses the contract and the second is that this should also motivate him to act as the principal wishes. Holmstrom introduced this principle, which states that an ideal contract should take into account all performance measures available to the agent in calculating compensation. This means that it must also take into account relative performance compared to other similar agents to eliminate the luck factor. To understand this, we can use the example of a manager whose actions influence the stock price of his company but not the stock prices of other companies. Should a manager's compensation depend solely on their company's stock price? No: since stock prices reflect other economic factors beyond the manager's control, only tying compensation to the company's stock price will reward the manager for his good luck but punish him for his bad luck. It is best to tie a manager's compensation to her company's stock price relative to that of similar companies and not just to the stock price she may strive to control. Likewise, CEOs should notbe allowed to benefit from exceptional gains resulting from favorable macroeconomic conditions. Appealing to the information principle, Holmstrom advocates the use of relative performance evaluation as a means of filtering out luck. Thus, in sectors where it is more difficult to measure the agent's effort, the less remuneration must be paid based on performance. Multitasking Sometimes the agent's job consists of many tasks and it is important to the principal that the agent distributes its efforts among tasks in a way that matches the principal's goals. This can be difficult when easy-to-measure activities and hard-to-measure activities compete for the agent's attention. For example, teacher performance could be evaluated based on student grades as well as curricular best practices where it is difficult to measure later. So if teacher salaries were determined primarily based on quantifiable outcomes, like test scores, teachers might spend too little time teaching more qualitative skills, like creativity. Therefore, a fixed salary, independent of performance measures, would lead to a more balanced effort. Some tasks are easy to measure while others are difficult, so care must be taken when designing the contract. Holmstrom gives the example of Wells Fargo, where employees made fake bank accounts to get bonuses because the contract was based on a quantifiable outcome, which it was not. accounts created. We can learn the following lessons from multitasking: Don't encourage competing tasks. To provide adequate incentives, pay more for an important task or pay less for competing tasks. When a task is difficult to measure, weak or no incentives may be preferable. Companies should find substitutes for performance incentives. Examples might be the ability to control work through task assignment, job design, and a variety of implicit and explicit rules set by the company. We can split the task into two tasks and assign them to two different agents. Where one would take on a task that is easily measurable and this task would have high performance incentives and the second agent would take on a task that is innovative and difficult to measure and this task would have low performance incentives . Conclusion Companies should have been careful when designing Employee incentive and performance-based pay models are not always suitable, as they are best suited to stable industries and jobs where success can be easily quantified. Furthermore, the information principle suggests that a contract should link payment to any outcomes that can provide information about actions. which were taken. This means that it should not only depend on the variables that the agent can control, but should be a form of assessment of relative performance. In short, there is much more than pay for performance. evaluates the performance incentive system and concludes that performance pay is not easy to implement. Additionally, it is best suited for industries and jobs where success can be easily quantified, such as sales and production industries. Pay for performance is also linked to market integration within the company. This means that the company's employees are competitors and will fight among themselves to get the most out of the company's limited resources. Holmstrom defends this model and.