Consider an entrepreneur who starts a small restaurant.
First, she works alone, cooking the food and serving customers. Then she hires a few employees to work with her, and they move into a larger space. The business grows and eventually the entrepreneur decides to open more locations and hire a manager to run the individual restaurants day-to-day operations for her while she focuses on running the business.
└── Terri (Owner of Terri's Amazing Restaurant)
├── Jackson (Manages Location 1)
└── Jason (Manages Location 2)Jackson and Jason now control the restaurants that Terri owns. She has hired them to run the restaurants while she focuses on other things.
Let's say that each manager has responsibility for:
└── Terri (Owner of Terri's Amazing Restaurant)
├── Jackson (Manages Location 1)
│ ├── Food
│ ├── Menu
│ └── Staff
└── Jason (Manages Location 2)
├── Food
├── Menu
└── StaffTo illustrate lets consider the case that arises when the restaurants begin to operate separate services for lunch and dinner.
└── Terri (Owner of Terri's Amazing Restaurant)
├── Jackson (Manages Location 1)
│ ├── Annalee (Dinner)
│ │ ├── Food
│ │ ├── Menu
│ │ └── Staff
│ └── Caleb (Lunch)
│ ├── Food
│ ├── Menu
│ └── Staff
└── Jason (Manages Location 2)
├── Robin (Dinner)
│ ├── Food
│ ├── Menu
│ └── Staff
└── Seth (Lunch)
├── Food
├── Menu
└── Staff└── Shareholders
└── CEO
├── African Division Manager
│ ├── Distribution Manager
│ ├── Plant Manager
│ └── Sales Manager
├── Asia-Pacific Division Manager
│ ├── Distribution Manager
│ ├── Plant Manager
│ └── Sales Manager
├── European Division Manager
│ ├── Distribution Manager
│ ├── Plant Manager
│ └── Sales Manager
├── North American Division Manager
│ ├── Distribution Manager
│ ├── Plant Manager
│ └── Sales Manager
└── South American Division Manager
├── Distribution Manager
├── Plant Manager
└── Sales Manager
Each link involves a principal and an agent, with the former delegating substantial authority for making decisions to the latter. At every level conflicts of interest arise.
Because they get to keep the profits.
The CEO can then choose an incentive scheme for every divisional manager, based on company profits or performance evaluation of the division (which may in turn be based on output, costs, divisional profits, ROI, etc.).
Consider the manager of a factory. An owner’s return on investment in the factory depends on many factors. For example, the market price of raw materials and finished goods, and the number of equipment breakdowns will affect the factory’s profit and the owner’s return. These factors will cause the performance of the firm to be uncertain. The owner’s return will also depend to some extent on how hard-working and/or talented the manager is. If the manager works hard (i.e., if he can keep the machinery in good condition, react quickly to breakdowns, treat workers well and maintain discipline, etc.), his effort will be productive in the sense that it will increase the overall probability of good performance. Outstanding effort on the manager’s part, however, will not necessarily result in good performance, because factors beyond the manager’s control (such as external price fluctuations or deficient raw material supply) may make bad performance inevitable.
Well, then, says I what's the use you learning to do right when it's troublesome to do right and ain't no trouble to do wrong, and the wages is just the same? I was stuck. I couldn't answer that. So I reckoned I wouldn't bother no more about it, but after this always do whichever come handiest at the time.
The Adventures of Huckleberry Finn Mark Twain, 1884
Beyond a certain point, Huck does not like to work. If every week Huck put in just forty hours, did not work too hard during any one of those hours, and took a reasonable paycheck home every Friday, Huck would be a happy guy. Sadly, Huck must do some things he finds unpleasant and hard in order to maintain his standard of living. Huck will not do these things unless he thinks the rewards outweigh his distaste for those activities.
This shouldn't be confused with being "lazy", effort aversion also comes, in the limit, from the basic diversity of human needs.
Huck makes widgets in Miss Watson’s factory. The number of widgets produced depends partly on Huck’s effort and partly on random events. Huck can work hard, experience bad luck and widget output will be low. Or, Huck could shirk his duties, but with good luck, widget output is high. Ideally, Huck always works diligently. On average, if Huck is diligent, widget output is satisfactory.
Informal interpretation of risk aversion: Holding the expected amount of pay constant, risk averse individuals get less value from less sure pay plans.
But, Huck may prefer a high variance/high mean pay plan to a low variance/low mean pay plan, depending on just how risk averse he is.
— Consider several firms operating in the same industry.
Since performance depends on a large number of variables beyond managers’ control, these managers may end up bearing a lot of risk.
In other situations—where the firm’s performance is totally independent of their actions, or where their actions can be directly observed by the principal—there is no need to impose so much responsibility on managers.