Seminar Paper, 2008, 20 Pages
How to Increase Team Performance?
An Overview of Incentive Systems, Peer Pressure and
“Economics of Organizations”
PhD Candidate - Doctorate in Economics, Management and Organizations
During the last decades, researchers in the area of personal economics have developed a bundle of possibilities to increase team performance. This paper wants to give an overview of the latest incentive schemes as well as concepts of peer pressure, norms and mutual monitoring. The ﬁndings of this paper are that a well-balanced integrated team incentive plan, which includes elements of rewards and of pressure is expected to be the most promising. The ideas in this paper are applied to a basic economic model that allows a deeper understanding of the concepts.
How to Increase Team Performance? 1
During the last 20 years, teamwork has become prevalent in many ﬁrms. While 1987, 27% of the ﬁrms supported self-managed teams, 1999 this number rose to 72% (Lazear and Shaw (2007)). Together with the increment of usage, the research of teams as a part of personal economics has increased. Many advantages of teams have been identiﬁed as reasons for the augmented use of teams. But also the negative eﬀects, organization, coordination and free-riding have been further analyzed. Special attention was given to the possibilities of increasing the team performance and mitigating the negative eﬀects. During the last decades, researchers and practitioners have developed a huge array of incentive schemes and bonus plans. These incentives can be monetary, non-monetary, they can be based on outcomes of the team and team members or on acquainted team skills. In addition to the incentive schemes, concepts of peer-pressure, mutual monitoring and punishments were further analyzed and improved. Today, an integrated, well-balanced usage of the methods promises a considerable improvement of team performance.
This paper begins with an analysis of the beneﬁts of teams, namely specialization and knowledge transfer. The third section explains the problem that is related with the usage of teams, the free-riding eﬀect. Section 4 and 5 oﬀer possibilities to increase the team performance and to mitigate the free-rider eﬀect. While Section 4 concentrates on incentives and bonuses, section 5 refers to the eﬀects of monitoring, pressure and punishment. In this context, a model including peer pressure and mutual monitoring is developed. Section 6 provides a numerical example for this model to clarify the concepts introduced section 5. Section 7 analyzes the concepts with regard to the team size before the following conclusion reﬂects and summarizes the ﬁndings.
2 The beneﬁts of teams
Why the usage of teams has become so popular during the last couple of decades? Actually, teams have many disadvantages. As Lazear and Shaw (2007) point out, the organization, selection and coordination of teams can be time consuming. Furthermore, an omnipresent, potential problem in teams is the free-rider problem, in which team members will free-ride on the eﬀort of the others.
Nevertheless, in certain circumstances, teams can have crucial advantages over individuals working alone. Generally, the beneﬁts from teamwork are the greatest if large complementarities between the tasks of two employees exist (Lazear (1998) p. 307).
How to Increase Team Performance? 2
The easiest example would be a physical labour that cannot be done by a worker alone. In this case, only a team can generate an output.
But teams have more direct beneﬁts to oﬀer: specialization and knowledge transfer.
Specialists can often work together more eﬃciently in a team. If each worker has access to the skills of the other workers, they can help each other with their speciﬁc knowledge and accomplish the task faster, as shown by Lazear and Shaw (2007). Therefore, gains from team interaction are greater when individuals have diﬀerent skills or information (Lazear (1999)). On the other hand, if the skill sets of the workers are completely overlapping, the individuals in the team do not have any beneﬁts from the specialization.
The second direct beneﬁt in teams, knowledge transfer among team members, is closely related to specialization. Without specialization of the team members, knowledge transfer cannot occur since all workers have the same knowledge. Actually, the workers must have distinct but relevant information sets as argued by Lazear (1998). Relevance means that the knowledge of one team member is helpful for the completion of another team member’s task. For example, while the knowledge of an accountant and an economist might be relevant and therefore knowledge transfer might occur, the same is unlikely to be true for an engineer and a lawyer.
However, putting workers with a very similar background in the same team will not result in knowledge transfer neither, since their information sets are nearly identical (Lazear (1998)). The two factors, specialization and relevance, should help to choose the right members for a team.
An important factor for the knowledge transfer is communication, as pointed out by Lazear (1999). Only if the team members are able to communicate with each other, they can discover their information sets and start to learn from each other in order to perform the tasks more eﬃciently.
The ideas of specialization and knowledge transfer are visualized in ﬁgure 2.1. The information sets of two specialized workers are displayed. The right rectangle denotes the information set of worker 1, the left that of worker 2. The smaller rectangle in the middle is where both information sets are overlapping. Since large parts of the infor- mation sets are not overlapping, there is a big potential gain from teamwork through
How to Increase Team Performance? 3
Figure 2.1: Information sets and tasks of workers in a team environment, Source: Authors depiction on basis of Lazear (1998)
knowledge transfer. However, the question if teamwork is valuable or not depends on the tasks that each worker has to do.
Figure 2.1 illustrates two cases. In the ﬁrst case, the workers have to do the tasks in the solid ellipses. Worker 1 alone does not have all the necessary knowledge to complete this task but together with worker 2 in the team, he is able to fulﬁl it. Similarly, worker 2 cannot fulﬁl his task alone but with the knowledge of worker 1 it is possible. Teamwork in this case has a clear beneﬁt.
The second case is illustrated by the dotted ellipses. Again, worker 1 does not have suﬃcient knowledge to fulﬁl this task but this time the knowledge of worker 2 would not be of any help for him, since part of the ellipse is outside the information set of both workers. The same is valid for the task of worker 2. In this case, the nonoverlapping parts of the information sets are irrelevant and teamwork will not have any beneﬁts.
To sum up, teams should be used generally when the explained beneﬁts of specialization and knowledge transfer overcome the costs associated with teams.
Empirical studies could conﬁrm the above stated theoretical frameworks. Hamilton et al. (2003) were able to conﬁrm the positive eﬀect of heterogenic, specialized workers within teams. Boning et al. (2007) made an inquiry in US steel mills and were able to show that in this environment of complicated problems, team systems have the greatest gains.
How to Increase Team Performance? 4
3 The free-riding eﬀect in teams
The free-riding problem in team production is one of the most investigated issues in literature of economics. It is based on the classical work of Alchian and Demsetz (1972), distinguishing partnerships and ﬁrms. They argue that the weakening of incentives in large ﬁrms will aggravate the free-riding eﬀect. Holmstr¨ om (1982) concludes that it is possible to overcome the free-riding problem with the enforcement of a bonus system that is able to implement eﬃcient eﬀort.
The main problem in teams is that the individual member bears the full personal costs of his eﬀorts but shares the gains from those eﬀorts with all team members (Baron and Kreps (1999)). Selﬁsh behavior and a trade oﬀ between the own eﬀort and the beneﬁts lead to purposely underperformance of the worker. Instead, he will rely on the eﬀorts of his co-workers in order to receive his share of proﬁts. Unfortunately, if all workers think and act in that way, an eﬃcient outcome will not be achieved.
The free-riding problem can be easily explained, using basic algebra. The following model is taken from Kandel and Lazear (1992). Each worker i can choose his individual eﬀort e i . The output of the team can be calculated as a function of all workers eﬀorts f (e). We assume that the output is equally shared among the N workers so that each
worker gets f (e) N . However, since eﬀort means a cost for a worker, a cost function C(e i ) has to be deducted from his utility. For an increasing eﬀort, the cost function increases with greater proportion C > 0, C > 0. Each worker wants to maximize
so the ﬁrst order condition is
It can be shown that the equilibrium eﬀort of the workers in this situation is lower then the optimal solution in which the total surplus is maximized
with the ﬁrst-order conditions
f i (e ) − C (e i ) = 0∀i. (3.4)
How to Increase Team Performance? 5
Since C > 0), the solution of e in (3.4) must exceed the solution of e in (3.2). Hence, the chosen level of eﬀort in a team is lower then the eﬃcient level.
4 Team performance through incentives
One attempt to lower the negative eﬀects of teamwork and especially the free-riding effect is to introduce team incentives. Hoﬀman and Rogelberg (1998) distinguish between seven systems of team incentives which we will summarize to four incentive systems depending on the factor that is evaluated. Each system has advantages and disadvantages is suited to special situations, which have to be considered before introducing a new team incentive scheme. In addition, incentives have to be separated in explicit and implicit rewards.
System I: Team gain sharing/proﬁt sharing
This system evaluates the outcome of the organization as a whole. A proﬁt sharing plan distributes some share of the company proﬁts to the team members. In contrast, gain sharing usually refers to non-ﬁnancial organizational successes like quality, productivity and consumer satisfaction (Miller and Schuster (1993)). Typically, the incentive does not only depend on the current year’s proﬁt but also on the diﬀerence between this year’s proﬁt and the past proﬁts.
A problem of proﬁt or gain sharing is the distance between the team’s performance and the basis for the incentives. Following Sisco (1992), a team will only improve its performance if it sees an impact of its eﬀort on the incentive measure. If the eﬀect on the company’s proﬁt or on the other gain sharing goals is minimal, departmental goals should be more eﬃcient than global goals (Nickel and O’Neill (1991)).
Another important factor is the distribution of the proﬁt and gain sharing. Recardo and Pricone (1996) argued that in organizations where cooperation among teams is important, the incentives should be shared evenly among the diﬀerent teams. In this way, the share of common goals can improve the cooperation of the teams. However, if cooperation is not an important factor within the organization, teams may also receive diﬀerent shares in dependence of their performance to increase the competition among the teams and with it team performance (Johnson et al. (1981)).
Not only the incentive distribution among teams but also the distribution among team members has to be considered. Similar to the distribution between teams, the allocation among team members is aﬀected by the need of cooperation. The higher the need for
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