The thing with having a blog is that it affects the way you see everything.  You can’t just let go and enjoy a movie, T.V. etc without the odd idea for a post popping into the back of your mind….So, last night I settled down to watch the first episode of “Mad Men” and I thought I concentrated fully and followed the plot. But now all I remember is that the new evil British guy (the Principal) appointed two people, Pete and Ken (the Agents) , “Head of Accounts” after sacking the sole previous incumbent.

This the classic incentive scheme recommended by the tournaments literature in contract theory. The main idea is that you get both Pete and Ken to work hard because if one underperforms relative to the other, he gets punished by lower wages, sacking etc.  Of course this transfers risk onto the agents and Pete particularly looked discomfited by the arrangement even though he got a promotion.  In fact, a classic paper by Bengt Holmstrom (which I already blogged about), recommends that this relative performance evaluation only be done if one agent’s output gives information about the other’s effort, otherwise you are just imposing risk without any incentive benefits.  So, if Pete and Ken were doing totally different jobs, the incentive scheme does not make any sense.  But since they are both working in Accounts if one, say Pete, does well and the other, Ken, does badly it signals that Ken might not have worked as hard as Pete.  If both do badly, it signals that the economy is bad and no-one shirked etc…So, it fits the theory.

One problem with relative performance evaluation is that Pete and Ken have an incentive to collude (Dilip Mookherjee pointed this out in his research).  Ken realizes this and suggests it to Pete but Pete turns him down.  Maybe there’s  a Prisoner’s Dilemma aspect to the collusion game or Pete was too emotional to get it.

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