Monday, October 6, 2014

Beware the Cobra Effect


  1. The video of the Cobra Effect was a great way for me to connect the principles of chapter 1 in your text Managerial Economics, a problem solving approach (3rd Ed). As written, “People act rationally, optimally, and self-interestedly; they respond to incentives.” (Froeb, McCann, Shor, & Ward, 2014) In the examples given in the video, it is said that people are willing to abuse animals, the environment, and the government, just to make money. It would be interesting to know if all the managers or decision makers in these scenarios did or did not have enough information to make good decisions; or lacked incentive to do so. (Froeb, McCann, Shor, & Ward, 2014) In the example of the factories, producing more pollution in order to get rid of it for credits- this is a perfect example of the decision makers having a problem of goal alignment, namely not thinking of the tradeoff. Every solution has costs as well as benefits. . (Froeb, McCann, Shor, & Ward, 2014) The costs were more damage to the environment then were probably there in the first place. The design here would be to change, or dissolve this type of incentive. Another solution could be to monitor the output of pollution; did it jump up after the incentive started? Obviously they figured this out eventually, but if there were more controls in place this wouldn't have happened in the first place. A great article about environmental incentives and how to manage them is titled Understanding financial reporting for green and stimulus incentives by Jennifer pang, Edward Abahoonie, and John Hayes and can be located at:

    Works Cited

    Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2014). Managerial Economics; A problem solving approach (3rd edition). Mason, OH: South-Western Cengage Learning .

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  3. The Rational Actor Paradigm tells us that people react rationally, optimally, and self-interestedly. They respond to incentives.
    This rationale is the basis for many “pay for performance” compensation models. One particular model ties individual performance and compensation to the organizations performance or profitability. In other words, rather than earning a flat hourly rate or base salary, employees have the opportunity to earn incentive pay base on their individual performance, department goals, and/or the organizations profitability, among other factors. Often times, under this model companies see increased productivity, increased employee engagement, and increased profitability. But, when does this model have potential for doing more harm than good?
    I will use an example from my own experience. In the mid ‘90s a particular organization in the construction industry was struggling to turn a profit. A determined leadership team put into place several initiatives to help turn the company around. One of the changes implemented was a pay for performance model that paid employees a base salary lower than industry standard, but that gave each individual to earn incentive pay equal to anywhere from 10% to 30% of the employees’ base salary (depending on the specific position’s impact on the business). In order for the incentive pay to come into play, the company itself needed to hit its minimum profitability goals for the year. Immediately following the implementation of the new pay for performance compensation program, productivity increased across the board and profitability grew to its high rates in the company’s history. So, could the success be sustained indefinitely?
    Indeed it could, if all market conditions remained the same. In fact, the success was sustained until 2008 when the economic downturn occurred. Being that the organization has a focus on the commercial construction business, profitability fell sharply in from ’09, ’10, and ’11. During that time, no employees were paid incentive pay, which meant they only received their base salaries, which were set at lower than industry standard. As you can imagine, engagement fell, turnover increased, and overall productivity dropped. When the organization moved to a more traditional compensation plan in ’12, which brought salaries up to industry standard and still offered incentive pay, but at reduced levels (5-15%), productivity, engagement, and profitability all increased drastically and measures show that each of those continue to rise. According to an employee opinion survey, 81% of employees responded favorably around questions regarding employee engagement in ’14 compared to 70% in ’12.
    The lesson here is that organizations should take into consideration the rationale behind the Rational Actor Paradigm, but they need to do so while taking into consideration the ebbs and flows of the economic conditions that exist within their respective markets, which may impact the effectiveness of pay for performance based compensation plans.

  4. This has always ticked me off. Incentives are there to drive performance but they often do the complete opposite, at least for the general population of employees. In a situation where the elite performers get big bonuses and the bottom performers get fired, all the guys in the middle do exactly enough to stay out of the bottom. To be fair I am sure many work as hard as they can until they have a bad month or have become totally aware of their average performance. It’s like they give up in the middle of the year if they are not in bonus contention, but they don’t give up enough to get fired. So basically the incentive that was offered in the beginning of year only drives the performance of the employees at the top of the heap by the middle of the year. According to the readings shirking is a type of moral hazard caused by the difficulty or cost of monitoring employees’ behavior after they have been hired (Froeb ET all, 2014). Average performing employees’ understand that their managers will spend more time addressing the bottom performers, while relying on the elite performers to get the difficult tasks done. Unless a firm incents every employee except the absolute lowest bottom performer, managers can expect the middle performers to shirk or simply stay off the radar.
    Froeb, L.M., McCann, B.T., Ward, M.R. & Shor, M. (2014). Managerial Economics: A Problem Solving Approach. Mason, Ohio: Southwestern Cengage Learning.