The paper uses the example of Enron's corporate failure to build a case for the principal-agent framework and analyses executive payment schemes. Aspects on the origins and possible solutions for the principal-agent relationship are looked into. The paper concludes that Enron's compensation scheme has led to its failure. Product Details. Average Review.
Write a Review. GRIN Publishing. At the same time, since equity may be seen as a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity, and stockholders may therefore take risky projects with negative net present values, which while making them better off, may make the bondholders worse off. See Option pricing approaches under Business valuation for further discussion. Nagel and Purnanandam notice that since bank assets are risky debt claims, bank equity resembles a subordinated debt and therefore the stock's payoff is truncated by the difference between the face values of the corporation debt and of the bank deposits.
Jensen and William Meckling, an increase in variance would not lead to an increase in the value of equity if the bank's debtor is solvent. The major problem in measuring employee performance in cases where it is difficult to draw a straightforward connection between performance and profitability is the setting of a standard by which to judge the performance.
One method of setting an absolute objective performance standard—rarely used because it is costly and only appropriate for simple repetitive tasks—is time-and-motion studies , which study in detail how fast it is possible to do a certain task. These have been used constructively in the past, particularly in manufacturing. More generally, however, even within the field of objective performance evaluation, some form of relative performance evaluation must be used.
Typically this takes the form of comparing the performance of a worker to that of his peers in the firm or industry, perhaps taking account of different exogenous circumstances affecting that. The reason that employees are often paid according to hours of work rather than by direct measurement of results is that it is often more efficient to use indirect systems of controlling the quantity and quality of effort, due to a variety of informational and other issues e. This means that methods such as deferred compensation and structures such as tournaments are often more suitable to create the incentives for employees to contribute what they can to output over longer periods years rather than hours.
These represent "pay-for-performance" systems in a looser, more extended sense, as workers who consistently work harder and better are more likely to be promoted and usually paid more , compared to the narrow definition of "pay-for-performance", such as piece rates.
This discussion has been conducted almost entirely for self-interested rational individuals. In practice, however, the incentive mechanisms which successful firms use take account of the socio-cultural context they are embedded in Fukuyama , Granovetter , in order not to destroy the social capital they might more constructively mobilise towards building an organic, social organization, with the attendant benefits from such things as "worker loyalty and pride Subjectivity is related to judgement based on a supervisor's subjective impressions and opinions, which can be expressed through the use of subjective performance measures, ex post flexibility in the weighting of objective performance measures, or ex post discretional adjustment, all of which are based on factors other than performance measures specified ex ante.
Whilst often the only feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures and supervisory schemes. One problem, for example, is that supervisors may under-report performance in order to save on wages, if they are in some way residual claimants, or perhaps rewarded on the basis of cost savings. Another problem relates to what is known as the "compression of ratings".
Two related influences—centrality bias, and leniency bias—have been documented Landy and Farr , Murphy and Cleveland The former results from supervisors being reluctant to distinguish critically between workers perhaps for fear of destroying team spirit , while the latter derives from supervisors being averse to offering poor ratings to subordinates, especially where these ratings are used to determine pay, not least because bad evaluations may be demotivating rather than motivating.
However, these biases introduce noise into the relationship between pay and effort, reducing the incentive effect of performance-related pay. Milkovich and Wigdor suggest that this is the reason for the common separation of evaluations and pay, with evaluations primarily used to allocate training. Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal labour markets Doeringer and Piore , Rosen as a solution to some of the problems outlined.
Here, there is "pay-for-performance" in a looser sense over a longer time period. There is little variation in pay within grades, and pay increases come with changes in job or job title Gibbs and Hendricks The incentive effects of this structure are dealt with in what is known as " tournament theory " Lazear and Rosen , Green and Stokey , see Rosen for multi-stage tournaments in hierarchies where it is explained why CEOs are paid many times more than other workers in the firm. See the superstar article for more information on the tournament theory. Workers are motivated to supply effort by the wage increase they would earn if they win a promotion.
Some of the extended tournament models predict that relatively weaker agents, be they competing in a sports tournaments Becker and Huselid , in NASCAR racing or in the broiler chicken industry Knoeber and Thurman , would take risky actions instead of increasing their effort supply as a cheap way to improve the prospects of winning.
These actions are inefficient as they increase risk taking without increasing the average effort supplied. A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers might become reluctant to help out others and might even sabotage others' effort instead of increasing their own effort Lazear , Rob and Zemsky This is supported empirically by Drago and Garvey Why then are tournaments so popular?
Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker performance.
Why the case of Enron falls into the Principal Agent framework - Vicki Preibisch - Google книги
Tournaments merely require rank order evaluation. Secondly, it reduces the danger of rent-seeking , because bonuses paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the most qualified person. Thirdly, where prize structures are relatively fixed, it reduces the possibility of the firm reneging on paying wages.
As Carmichael notes, a prize structure represents a degree of commitment, both to absolute and to relative wage levels. Lastly when the measurement of workers' productivity is difficult, e. Tournaments also promote risk seeking behavior. In essence, the compensation scheme becomes more like a call option on performance which increases in value with increased volatility cf.
If you are one of ten players competing for the asymmetrically large top prize, you may benefit from reducing the expected value of your overall performance to the firm in order to increase your chance that you have an outstanding performance and win the prize. In moderation this can offset the greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of public companies the principal typically owns his stake as part of a diversified portfolio.
Successful innovation is particularly dependent on employees' willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth paying for the greater chance of success through innovation elsewhere in the portfolio.
If however the risks taken are systematic and cannot be diversified e. Tournaments represent one way of implementing the general principle of "deferred compensation", which is essentially an agreement between worker and firm to commit to each other. Under schemes of deferred compensation, workers are overpaid when old, at the cost of being underpaid when young. Salop and Salop argue that this derives from the need to attract workers more likely to stay at the firm for longer periods, since turnover is costly. Alternatively, delays in evaluating the performance of workers may lead to compensation being weighted to later periods, when better and poorer workers have to a greater extent been distinguished.
Workers may even prefer to have wages increasing over time, perhaps as a method of forced saving, or as an indicator of personal development. For example Akerlof and Katz if older workers receive efficiency wages, younger workers may be prepared to work for less in order to receive those later. Overall, the evidence suggests the use of deferred compensation e. The "principal—agent problem" has also been discussed in the context of energy consumption by Jaffe and Stavins in They were attempting to catalog market and non-market barriers to energy efficiency adoption.
In efficiency terms, a market failure arises when a technology which is both cost-effective and saves energy is not implemented. Jaffe and Stavins describe the common case of the landlord-tenant problem with energy issues as a principal—agent problem. The energy efficiency use of the principal agent terminology is in fact distinct from the usual one in several ways. Is the agent the landlord and the principal the tenant, because the landlord is "hired" by the tenant through the payment of rent? As Murtishaw and Sathaye, point out, "In the residential sector, the conceptual definition of principal and agent must be stretched beyond a strictly literal definition.
Another distinction is that the principal agent problem in energy efficiency does not require any information asymmetry: both the landlord and the tenant may be aware of the overall costs and benefits of energy-efficient investments, but as long as the landlord pays for the equipment and the tenant pays the energy bills, the investment in new, energy-efficient appliances will not be made.
- LESSONS LEARNED FROM ENRON'S COLLAPSE: AUDITING THE ACCOUNTING INDUSTRY
In this case, there is also little incentive for the tenant to make a capital efficiency investment with a usual payback time of several years, and which in the end will revert to the landlord as property. Since energy consumption is determined both by technology and by behavior, an opposite principal agent problem arises when the energy bills are paid by the landlord, leaving the tenant with no incentive to moderate her energy use.
This is often the case for leased office space, for example. Rarely, if ever, do the followers have the opportunity to reciprocate this momentum and impact the leader in a genuine fashion.
A final, and likely the greatest, criticism of transformational leadership theory is its potential for abuse by leaders. But who is to determine if the new directions are good and more affirming? They led the company to unprecedented heights that few believed could be achieved by a natural gas company. At Enron, however, this morally absent form of transformational leadership became a double edged sword that eventually cut off executive leaders like Lay from the financial reality existing around them.
This disconnect with reality, coupled with the general lack of integrity on the part of leadership, ultimately fed into a culture of narcissism; a culture that permeated throughout the entire organization. In the following paragraphs two ethical frameworks will be utilized to help explain what was missing in the leadership at Enron that allowed its particular culture to develop. From an ethical perspective, one need look no further than the tradition of ethical egoism to help explain how and why a culture of narcissism emerged within Enron.
Within the broad parameters provided by that definition, Pojman argues that there are roughly four different types of ethical egoism: psychological egoism, personal egoism, individual egoism, and universal ethical egoism pp.
In order to become theoretically grounded, universal ethical egoism makes use of a sophisticated argument that consists of individuals giving up their short-term interests in pursuit of long-term ones. At the core of the argument lies the concept that everyone is encouraged to seek their own self-interest, however, in order to do so, some compromises are necessary. This type of rationalized self-interest forms the basis of the universality of ethical egoism and helps to conceptualize, at least from an egoist perspective, the basic foundations of Hobbesian liberty. Remarkably, the leaders at Enron i.
Enron Case Study
Lay, Skilling, Mark, et. At Enron, the pursuit of rationalized self-interest was taken to such an extent that the concept of compromise, even at the expense of other ethical considerations like integrity, became nomenclature for how to do ethical business in a capitalistically based free market economy. As mentioned above, integrity was a non-factor and a complete missing link for leadership when it came to establishing a bottom line for subordinates, a bottom line based solely on profit maximization and performance increase in the market share value of the company. Without an honest system of accountability or practiced standard of ethics in place within the leadership hierarchy at Enron, group members fell prey to a culturally reinforced mentality of serving their own rationalized self-interests at the expense of the overall health of the company and its shareholders.