Tenant Farmers


Companies often tax their employees. For example, imagine that you rent land to a farmer. You are considering three ways of extracting money from your worker:

  1. You pay the farmer a fixed amount to work for you, but you keep all of the crops he grows.

  2. The farmer gives you a percentage of everything he grows.

  3. The farmer pays you a fixed fee, but he keeps everything that he grows.

The farmer has the least incentive to work when paid a fixed fee. Under the first scheme, the farmer gets paid the same amount regardless of his effort, so it’s in his self-interest to work as little as possible. Taking a percentage of what the farmer grows it the equivalent of taxing him. Under the second plan the farmer still has some incentive to work, but this incentive is greatly reduced by your implicit tax. The farmer has the greatest incentive to work if he must pay you a fixed fee. Under this scheme, if the farmer works a little harder, he captures all of the benefits of his efforts.

Imagine that the farmer could work an extra hour and produce $30 more in crops. Under plan (1) he would get none of this extra money, under plan (2) he would get some of it, while under plan (3) he would get the full $30.

It might therefore seem then that you should always use plan (3) and have the farmer pay you a flat fee. The problem with the third plan, however, is that it puts all the risk of crop failure on the farmer. If he has a bad year, the farmer absorbs all of the losses. Since most workers dislike risk, workers usually accept risk only if they are compensated for assuming it. The farmer will agree to the third plan, therefore, only if he gets a high average income. Under plan (3) the farmer must expect to make a lot of money in good years to be compensated for a low income in bad years.

This tradeoff between risk and work always exists for employers. To motivate employees to work, you usually need to make their salary dependent on how well they perform. Employees, though, usually dislike risk and prefer steady, consistent paychecks. Firms face a difficult choice. If a firm forces its workers to take on high risk, the workers will be motivated to work, but will dislike this risk. If the firm pays employees a constant amount, the workers will be happy with their safe jobs but may have little incentive to work hard. The following game illustrates this employers’ dilemma.

Assume that a salesman can either (a) work hard or (b) slack. The employer can’t observe the salesman’s efforts. The salesman will either do well or poorly. If the salesman slacks off, he will always do poorly. If, however, the salesman works hard, he will do poorly half of the time and do well the other half.

Table 8

Work Hard

Slack Off

Low Sales

50% of the time

100% of the time

High Sales

50% of the time

0% of the time

How should the firm pay the salesman? If it always pays the salesman the same amount, the salesman obviously has an incentive to slack off. If, however, the salesman’s salary is based on his outcome, then he will be forced to take on a lot of risk, for even if he works hard, he still might have a bad year. If you make employees take on too much risk, they will demand greater salaries or will seek safer jobs.

The one way around the risk/motivating tradeoff is for employers to carefully monitor efforts, not outcomes. In the previous game, you could achieve an ideal result if you paid the salesman based on how hard he worked, not his total sales. An employee willing to work hard would then face no risk. Unfortunately, determining effort is always subjective and much more challenging than monitoring outcomes. There is consequently no always-right solution to the risk/motivation problem; rather, each company must accept that any pay structure will cause some inefficiency and seek to determine which inefficiencies cause the least harm.

The tradeoffs between risk and reward are also an important topic in finance; this book further explores them in Chapter 16, The Stock Market.




Game Theory at Work(c) How to Use Game Theory to Outthink and Outmaneuver Your Competition
Game Theory at Work(c) How to Use Game Theory to Outthink and Outmaneuver Your Competition
ISBN: N/A
EAN: N/A
Year: 2005
Pages: 260

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