PRINCIPALS, AGENTS, AND MOTIVATION
During the same decades that professional expertise was coming under fire, the business corporation also came in for critique as favoring the interests of its managers over those of its shareholders.
The notion picked up steam in the 1970s and achieved a kind of academic quintessence in “principal-agent theory.”1 The version of the theory prominent in the management literature calls attention to the gap between the purposes of institutions and the people who run them and are employed by them. It focuses on the problem of aligning the interests of shareholders in maximum profitability and stock price with the interests of corporate executives, whose priorities might diverge from those goals. Principal-agent theory articulates in abstract terms the general suspicion that those employed in institutions are not to be trusted; that their activity must be monitored and measured; that those measures need to be transparent to those without firsthand knowledge of the institutions; and that pecuniary rewards and punishments are the most effective way to motivate “agents.”2 Here too, numbers are seen as a guarantee of objectivity, and as a replacement for intimate knowledge and personal trust.3
Principal-agent theory led at first to schemes to remunerate CEOs with bonuses based on the profits and stock price of the companies they headed. Later, it morphed into plans to provide top managers with stock options of their companies. The idea in each case was to align the incentives of the managers with those of the owners of the firm, whose sole interest was presumed, quite plausibly, to be the profitability of the company.
Principal-agent theory conceives of organizations as networks of relationships between those with a given interest (the principals) and those hired to carry out that interest (the agents). The perspective is that of the principals, and the premise is that the interests of the agents may diverge from those of the principals. The interests of the shareholders of a company, for example, may be to maximize profits and returns on their capital. But the interests of their managers might be to have ostentatious offices and conspicuous private planes that raise their status, and the interests of lower-level employees might be to claim a salary while minimizing their workload. The challenge for the principal is to incentivize the agents to carry out his priorities, rather than their own priorities. A corollary problem for the principal is that of monitoring: how can he know what his agents are actually doing, and how well they are carrying out his goals? The twin tasks of organizations thus becomes how to provide information to organizational superiors about the activities of their subordinates, and how to create systems of reward to align the interests of the agents with those of the principals. The quest for information leads to performance metrics: standardized numbers that will efficiently convey to the principals how well their agents are carrying out the principals’ goals. Aligning incentives is taken to mean giving monetary rewards to employees that reflect the profitability of the firm: when the firm makes more money, so do the employees.
The professional management literature derived its own conclusions from principal-agent theory: that management is a matter of setting clear goals, and then of monitoring and incentivizing. It relies upon information and reporting systems on the one hand, and cleverly structured rewards on the other.
NEW PUBLIC MANAGEMENT
Beginning in the 1980s, this sort of thinking was extended from profit-making corporations to government agencies and such nonprofit organizations as universities and hospitals. Discontent with the costs, dissatisfaction with outcomes, or simply the desire to save money led critics to argue that the problem with these organizations was that they needed to function “more like a business.” That was the battle-cry of advocates of what became known as the “New Public Management.” The principals were in the first instance those who paid for agencies and nonprofit organizations: in the case of government, the taxpayers. The organizations’ students, patients, or clients were now to be regarded as their customers.
One difficulty, for those who sought to make such organizations more like a business, was that there was no price mechanism by which to determine whether those who supplied the funds were getting good value for their money. In a competitive market, consumers can compare the price of goods and services with the quality of the products on offer, and can make informed decisions about what to buy. Prices convey a lot of information in a concise, transparent form. But how were the taxpayers to evaluate schools, universities, hospitals, government agencies, or charitable organizations?
To resolve these difficulties, those who sought to make nonprofit organizations more businesslike suggested three strategies. The first was to try to develop indicators that would measure performance and would serve as a replacement for price.4 The second was to offer monetary rewards and punishments, based on measured performance, to those who worked in these organizations. The third was to provide competition among providers whose performance indicators would be “transparent,” that is, publicly available. The idea, in short, was to create marketlike conditions within the government and nonprofit sectors; and thus to run them “more like a business.” That was the way of thinking dubbed the “new public management.” It reflected a broader trend of importing principles from microeconomics into public administration and public policy.5
From the beginning, there were critics who tried to draw attention to the flawed premises of this approach, such as the economists Bengt Holmström and Paul Milgrom, as well as Henry Mintzberg, a professor of management at McGill University in Montreal.6 Mintzberg pointed out in the mid-1990s that the conception of management adopted by advocates of the New Public Management was a simplified caricature of what effective managers in private-sector firms actually did. It did conform, though, to what many students of management were being taught in business schools and in the burgeoning literature of business advice. Even then, it was inappropriate for government and nonprofit organizations, he argued. Business corporations have divisions where each unit has a clear mission to deliver a particular set of products or services; but government agencies and nonprofit organizations are characterized by multiple purposes, which are difficult to isolate and to measure. New Public Management schemes are plausible solutions for dealing with units of government that produce a single product or service, such as issuing passports. But that is the exception rather than the rule. Moreover, in business there are clear financial criteria of success and failure: costs and benefits can be compared to determine profits, and managers can plausibly be rewarded on that basis. But in government and nonprofit organizations there are rarely single goals, and they cannot be readily measured. Primary schools, for example, have their tasks of teaching reading, writing, and numeracy, and these perhaps could be monitored through standardized tests. But what about goals that are less measureable but no less important, such as instilling good behavior, inspiring a curiosity about the world, and fostering creative thought?
There is a larger problem. Firms are in the business of making profits, and their employees work at their jobs primarily to make money. (Which does not mean that money is their ultimate goal, only that they work in large part to earn money to use for their own, nonmonetary purposes.) People who choose to work for government agencies and nonprofit organizations, such as schools, universities, hospitals, or the Red Cross, are also interested in earning a living, but they tend to be more motivated by a commitment to the mission of the organization: to teach, to research, to heal, to rescue. They respond differently to the lure of monetary rewards, because their motivations are different, at least in degree.7
EXTRINSIC AND INTRINSIC REWARDS
Many of the problems of pay-for-performance schemes can be traced to an overly simple, indeed deeply distortive, conception of human motivation, one that assumes that people are motivated to work only by material rewards. For some are motivated less by extrinsic monetary rewards than by various sorts of intrinsic psychic rewards, including their commitment to the goals of the organizations for which they work, or a fascination with the complexity of the work they do, which makes it challenging, interesting, and entertaining. The existence of intrinsic as well as extrinsic motivations is obvious to anyone who has managed workers in complex tasks. It was articulated in the mid-1970s by psychologists, and has since been rediscovered and formalized by economists, including Jean Tirole, a recent recipient of the Nobel Prize for economics.8
It is simple-minded to assume that people are motivated only by the desire for more money, and naive to assume that they are motivated only by intrinsic rewards. The challenge is to figure out when each of these motivations is most effective, and in recent years social scientists have devoted attention to that issue.
In general, extrinsic rewards—pay-for-performance, incentive pay, bonuses—are most effective in commercial organizations, where the primary goal is to make money. They also work well when the task to be completed is discrete, easily measured, and not of much intrinsic interest, such as the production of some standardized good on an assembly line.
Some rewards enhance intrinsic motivation. For example, when the rewards are verbal and expressed primarily to convey information (“You did a great job on that!”) rather than to exercise control.9 Or when awards are given out after the fact, for excellence in achievement, without having been offered as an incentive in advance.10 Or, in fields such as science or scholarship, when prizes or honorific titles are bestowed to recognize long-term achievement.11 More broadly, above-market wages can reinforce employees’ intrinsic motivation if those wages are perceived as a signal of the organization’s appreciation of the employees’ performance.12 Intrinsic and extrinsic motivation can work in tandem when the outcomes that are rewarded are in keeping with the agents’ own sense of mission: when hospitals, for example, are rewarded for better safety records.
But when mission-oriented organizations try to use extrinsic rewards, as in promises of pay-for-performance, the result may actually be counterproductive. The use of extrinsic rewards for activities of high intrinsic interest leads people to focus on the rewards and not on the intrinsic interest of the task, or on the larger mission of which it is a part. The result is a “crowding out” of intrinsic motivation: having been taught to think of their work tasks primarily as a means toward monetary goals, they lose interest in doing the work for the sake of the larger mission of the institution.13 Alternatively, they may perceive the offer of payment for performance as an insult to their professional ethics, and indeed to their self-esteem, implying that they are in it for the money. Therefore, the assumption that extrinsic rewards encourage performance makes a lot of sense if one is an investment banker, but not if one is a teacher or nurse. Trying to turn everything into a business, then, gets in the way of the actual business at hand.
Indeed, it impedes actual businesses. Ironically, even as corporations were falling over one another to develop incentive schemes based on pay for measured performance for their top executives and employees, and such schemes were being touted as appropriate for the government and nonprofit organizations, top theorists of principal-agent behavior by the end of the twentieth century were exploring the weaknesses of such systems. By 1998, Robert Gibbons, a professor of organizational economics at MIT, pointed out that in fact the principal (the owner of the firm, for example) profits from a variety of outputs from the agent (the employee), and that many of these outputs are not highly visible or measureable in any numerical sense. Organizations depend on employees engaging in mentoring and in team work, for example, which are often at odds with what the employees would do if their only interests were to maximize their measured performance for purposes of compensation. Thus, there is a gap between the measureable contribution and the actual, total contribution of the agent. As a result, measured performance (such as an increase in the division’s profits or a rise in the company’s stock price) may actually lead to the organization getting less of what it really needs from its employees. Moreover, there was an inevitable distortion of incentives created by the quest for simple, quantifiable standards by which to measure and reward performance. Gibbons concluded that at best, economic models that ignore the range of psychological motives for why agents derive reward from working provide a truncated conception of motives. At worst, “management practices based on economic models may dampen (or even destroy) non-economic realities such as intrinsic motivation and social relations.”14
By the end of the twentieth century, students of organizational behavior like Gibbons were calling attention to the pitfalls of appeals to extrinsic motivation. But by then, schemes based upon simple conceptions of incentives, extrinsic reward, and New Public Management were already well entrenched.
These managerial fashions began in the corporate sector but quickly spread beyond it, above all in the Anglosphere (Great Britain, the United States, Australia, and New Zealand). To try to improve the management and efficiency of the public sector, the Conservative government of Margaret Thatcher established official bodies, some staffed by businessmen and management consultants, with titles such as the Efficiency Unit, the Financial Management Unit, the National Audit Office, and the Audit Commission. From Britain, the fashion spread to Australia and New Zealand, and to other OECD countries, carried beyond national borders by management gurus, consultants, and academics peddling tools and models of “best practice.”15