Hart and Holmstrom on aligning interests (and employment decisions)

1. This (re)post contains an excellent summary of what two Nobel laureates say about the best way to align interests of owners and employees. It contains a link to a more detailed summary in MRUniversity that is also excellent. The Nobel laureates are Oliver Hart and Bengt Holmstrom. Here are the basic elements.
2. The premise is that supervisors want to hire employees who work hard and reward them for doing so.
3. Output of an employee depends on how hard the employee works and luck. For example, a salesperson may have a great year when she works hard or when she is lazy and lucky. She can have a bad year even when she works hard because she is unlucky. 
4. Supervisors can observe signals of how hard the employee works. A signal contains information and noise. For example, output may be a signal. When output is a signal the supervisor knows that, on average, salespeople with high output work hard. The supervisor also knows that an individual salesperson may be lazy and have high output because she is lucky.  
5. The best compensation scheme uses all of the signals available to the supervisor to determine the reward to a worker.
6. The best compensation scheme places more weight on the signals that have the least noise. As noise decreases, the signal becomes more reliable. For example, suppose that output depends only on how hard someone works and that luck plays no role. In this case, the supervisor should measure output and use it and it alone to determine the reward. 
7. The best compensation scheme compensates risk averse employees with a higher base salary.
8. The best compensation scheme uses relative performance metrics ("tournaments", rankings) when employees have similar abilities.
9. The best compensation scheme uses absolute performance metrics when employees do not have similar abilities.

The post critiques compensation schemes that reward CEOs when the firm's stock does well because much variation is noise. Changes in the stock market affect the price of all stocks. Therefore, rewarding the CEO for appreciation often is a reward for being lucky, that is, being the CEO during a bull market. 

A better signal is the difference in return on the stock market between the firm and its competitors. This difference is more closely tied to what the CEO does and less affected by noise created by bulls and bears. In other words, a tournament may be best for CEOs.

Here is a key takeaway. When designing a compensation scheme, think about what you want to reward and what you can measure that is a signal. Identify the strongest, least noisy signal and put more weight on it in the compensation scheme. Daryl Morey spend years refining how to measure expected productivity of basketball players. He discovered that points per minute is a better signal than points per game and that points per possession is even better. Even then, noise beset him. He passed on drafting one player because a photo of the player without a shirt revealed man boobs and another player whose statistics were low because the player hated his college coach. 

Here is my final thought. Much of the analysis applies to measuring qualities of employees to hire. Think about the qualities you seek in the applicant and what you can measure that is a signal. Identify the strongest, least noisy signal and put more weight on it in the selection process.

Are strategic plans worthless?

Think about the strategic plan at your organization.

1. Does the organization publish the plan in a document?
2. Do most of the "workers respond to the plan by nodding and smiling in public while sighing and rolling their eyes in private"?
3. Does it begin "with an anodyne statement of principles, lists several general goals, and finally recounts a series of initiatives that the institution will undertake to realize these objectives"?
4. Does it state "that the company 'seeks to be a leader'”?
5. Does it set “stretch” targets?
6. Does it clearly identify where the activities on which the firm will focus and which it will avoid?
7. Does the plan align with the organization's budget?
8. If the plan and the budget diverge, which is a better guide to the firm's priorities?

This opinion in the WSJ (Oct. 2019) criticizes what many organizations call a strategic plan. The critique resonates with me. Many strategic plans are not plans and even fewer are strategies, imo.

One relevant comment to the post follows.

"It is axiomatic: an organization's "strategy" is where it spends its money. The corollary is: since every organization spends money, every organization has a strategy. Not every organization has a PLAN on how to spend money. A company that has no plan for spending invites (and usually gets) chaos, dissension, and sub-optimal returns on spending and investment. Some run out of cash. Others run out of customers.

"I've been involved in strategic planning for 40 years. Like all management pursuits, its been wasteful, enormously helpful and everything in between. It is vastly under-rated, and under-used, as a communication tool in large complex organizations. Good planning works when it helps focus choices and resource use. When you shoot at every leaf that moves, you run out of ammo. Fast.

"That people have been subjected to lousy processes isn't an indictment of planning; it's an indictment of, well, lousy process."

Versioning, bundling both of the same good and with complementary goods, and two-part pricing

This story reports that the SF 49ers have bundled season tickets (a bundle of single-game tickets) and unlimited food and beverages. This package combines versioning, bundling both of the same good and with complementary goods, and two-part pricing.

Can you trust what a job applicant reports?

A recent study reports that a substantial number of CVs embellish the accomplishments of the candidate. Verifying information is costly and many employers probably accept what is written without question.

FYI: CV = Curriculum Vitae, sort of a résumé for people seeking teaching or research jobs.

Facebook could increase profit by using price discrimination

This paper explores how Facebook could profitably employ price discrimination. "We find that a profit maximizing platform should decrease fees or advertising for users who elastically demand the platform (the direct effect) and who create high amounts of network value for other profitable users who themselves demand the platform elastically(the network effect). ... Facebook could increase profits by decreasing the amount of advertising on some market segments and increasing it for others.|

In this opinion in the WSJ (Oct. 2019), Andy Kessler discusses the role of technology in creating a competitive advantage and strategy.

Writing Well is Difficult

This article in the WSJ (Oct. 2019) describes the problems the SEC is having getting financial advisers to write well.

My reaction: Gut Instinct is Information

I stress the importance of gathering information to improve the information flow to deciders. This article in the WSJ (Oct. 2019) cautions against relying solely on data analytics when making decisions. 

An example of using the power of the government to raise barriers to entry

Why would Kentucky have a law that lets incumbent firms stifle entry into the ambulance industry? One answer: to help the incumbents earn profit in the long run.

Can the five forces model help you in the stock market?

Andy Kessler's advice sounds like an argument for using industry analysis to find where the grass is probably greener.

Why are prices for prescription drugs so high?

ReadClear Policy (Oct. 2019) describes the role of and incentives facing pharmacy benefit managers, or PBMs. Spoiler alert: the incentives encourage the managers to negotiate for higher prices.

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