Wednesday, February 23, 2011

Class # 9 Take Aways

In the huddle
A Teams Problem

In class #9, we talked about the teams or partners problem. The problem goes like this: two partners work on a project. Each unit of effort returns 1+x dollars and imposes a personal cost of $1. Assume x < 1.

The problem is that individual effort cannot be directly observed.
Working alone and receiving the full value of output, each partner is willing to work all out. But working as a team, then any profit sharing scheme will lead the partners to (optimally) free ride. It is a dominant strategy not to work at all.

This is a version of the holdup problem. The holdup problem occurs when another party can capture part of value created. Consider a 50-50 profit share. Now, each unit of effort produces 1+x dollars for the partnership, but the individual partner only gets half of this, which is less than the personal cost of effort.

One solution to the partners problem is to set threshold type incentives. Here, the idea is that pay is based on a sliding scale of total output. In the simplest version, partners only get paid if company profits exceed some target and not otherwise. This transforms the game into a stag hunt. Now cooperation is an equilibrium, but so is shirking. The culture of the organization determines which regime will prevail.

An aside: If the partners work for an outside manager, this scheme works fine, but it won't work so well if the partners own the company. The reason is that, for the scheme to work, the partners have to commit not to be paid in the event the target is not reached. But if they own the company's profits, they cannot really do that. The situation here is even worse, requiring some sort of repeated game incentives to sustain cooperation.

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