Implicit and Explicit Incentives for Managers – Compliments or Substitutes? – simplified

Explicit and implicit incentives are substitutes:

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Explicit and implicit incentives are substitutes:

Alpha Inc. is embarking on a major expansion in a new market. Management is fully aware that if expansion is not handled well, the whole corporation as well as their own jobs will be in jeopardy.  This is an example of presence of strong implicit incentive. Will it help if management is provided with explicit incentives? Not really, as they will put their best any way to save their jobs.  Thus strong implicit incentive has substituted explicit incentive. (Substitution effect)

Will this apply in every situation and in every corporation?

No. In some situations, explicit and implicit incentives can be very close substitutes, not substitutes or even be complements.

Three examples of interesting situations:

1.  Gordon, a very confident CEO, is heading a very successful software business. Shareholders want to achieve 10% growth in earnings every year and he is confident that the business will be able to grow at a rate higher than even 15% for next few years if things stay the same. His employment contract mentions that he will be fired if business growth is negative in any consecutive two years. Gordon has never worried about his job security based on his estimates of business over next few years. He enjoys his private jet and golf. Is there a strong implicit incentive to work hard? No. The corporation should offer strong explicit incentive to Gordon, for example, stock options for every additional 1% growth in sales. This will clearly improve Gordon’s focus on achieving higher growth in sales as he is confident in his skills.

2. Joe is CEO of The Plumber Inc. He always wanted to get to a position where he can work without boss. He is really happy to be CEO and wants to stay there as long as possible. He hates taking risk and likes to fish and hike.  He hardly cares for getting additional bonus for his performance as this involves taking risk. However, he can be motivated to work hard by presence of implicit incentive (e.g. threat of take over, removal from job if business underperforms certain benchmarks).

3. Tiger is the head of Mom China Inc.  The corporation is in financial distress. It has already considered Chapter 11 bankruptcy and is heavily dependent on continued support of the creditors. Tiger can receive huge bonus if the corporation achieves certain growth milestones.  His contract also mentions that he will be fired if the firm goes in bankruptcy or is taken over. Explicit and incentive incentives are both low. There are hardly any chances of growth. Furthermore, there is low probability of not being fired. Tiger will not have incentive to improve situation as he is convinced that it is inevitable that he will loose his job. Explicit and implicit incentives are compliments in this case.

Conclusion: Explicit and Implicit incentives can be substitutes in some cases and compliments in other.

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