My question is about the relationship between Implicit and Explicit Incentives. It’s on CFA Curriculum Volume 4 P277 and on Schweser Notes Book 4 P64. What’s on the Curriculum and Notes: In both the Curriculum and the Notes, in the 1st paragraph, it’s said that the two are substitue. If either of them is high, the need for the other is less. This is easy for me to understand. But then in the Curriculum, the 2nd paragraph said that high turnover and low pay have postive comovements, which proves complement relationship. And the 3rd paragraph said that high turnover and low pay have negative comovements, which proves substitue relationship. (Notes change the sequence of 2nd and 3rd paragraph, but in essence saying the same thing.) My confusion is: High turnover should mean high implicit incentive and low pay should mean low (NOT HIGH) explicit incentive. So for the 2nd paragraph, positive comovement between high turnover and low pay is actually suggesting complement between high turnvoer and low pay, but NOT suggesting complement between implicit and explicit incentives. I just can’t figure it out. Please help. Many thanks!
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If managers are in a weak position they can get shafted financially (explicit incentives) and if they don’t deliver the performance they will exit upon this being realised. Hence in this case we observed a positive co-movement between the two i.e. low explicit incentives and high turnover in the event of poor performance. However, in instances when managers known better about prospects than those that determine their compensation (BoD comp. committee) then you’d expect that they’d enter high explicit earning contracts but do not observe high turnover (as they already knew that the company was going to do okay when entering the contract). Hence in this instance it appears as they explicit and implicit incentives are negatively correlated. i.e. substitutes. This boils down to unobserved heterogeneity amongst managers’ knowledge (info asymmetry) and bargaining power. Hope this helps.
Thanks for respoding, as this question took me 4hours… So high turnover is deemed as implicit incentives. (no question. This is the definition in the curriculum.) And low-powered pay is deemed as explicit incentives. (I don’t agree, cuz it’s said high performance pay is explicit incentives in the first paragraph, which is supported by the two examples in that paragraph.) Therefore, “the positive comovement of high turnover and LOW pay” should suggest “negative comovement of high turnover and HIGH pay”, which equates to negative comovement of implicit and explicit incentives, so the relationship of the two is substitute. Please let me know your thoughts on this.
Anything financial - bonus, annual salary, stock options, stock is explicit. It’s tangible. Other incentives etc…are implicit. E.g. being fired, threat of bankruptcy etc… High powered PAY is explicit yes (it’s financial). But having to leave if your performance is bad is an implicit incentive. We should observe in case 2 (i.e. when managers know best about performance) higher pay and low turnover. They move in opposite directions and hence are negatively correlated and thus substitutes.
Yeah, regarding the definition, I believe we agreed as follows: “High turnover is treated as significant implicit incentive; while low turnover is treated as insignificant implicit incentive. And high performance pay is treated as significant explicit incentive; while low pay is treated as insignificant explicit incentive.” So now I turn to case 2, I believe you are referring to the 3rd paragraph on the curriculum on p277. It says turnover and low-powered pay are with negative covariance. So should’t it mean HIGH turnover are negative correlated to low-powerd pay?
Correlation is computed by standardising a covariance i.e. dividing the latter by two variables - in this case pay and performance turnover - standard deviations. I’d say what word you use is irrelevent as the meaning is the same. i.e. corr(pay, turnover) = covariance (pay, turnover) divided by (sd(pay)*sd(turnover))
This is how i did it…it confused the crap out of me too…but i managed to make it more mathematical and now i am comfortable…i hope it helps you too… Strong implicit incentive (getting fired) + weak explicit incentive (high performance pay) = bad motivational tool + good motivational tool = substitutes Strong implicit incentive (getting fired) + strong explicit incentive (low performance pay) = bad motivational tool + bad motivational tool = compliments I guess you could play around with that until you get comfortable… cheers…
to Dark Knight: I think the word high and low is put comparing with medium pay, so they are relevant in the sense that if you change the sign of all the inputs of one variable, the covariance change the sign as well. Therefore, if you say HIGH turnover has positive correlation with high pay. it means that LOW turnover has negative with high pay. Or put it this way if a is postively correlated with b, then -a must be negatively correlated with b. to sparty419: Thanks for sharing. I don’t understand why you say strong implicit incentive is bad motivational tool and why high performance pay is weak explicit incentive?
Well…since you know there’s a high probability of you getting fired…or getting a low pay…there is a stronger incentive for you to work your butt of harder so that u dont get fired or u dont get low pay… if u know your already gonna get a high pay…then its a weak motivational tool cuz u really dont have to slog as much…kinda goes along those lines… get it??
Well…since you know there’s a high probability of you getting fired…or getting a low pay…there is a stronger incentive for you to work your butt of harder so that u dont get fired or u dont get low pay… if u know your already gonna get a high pay…then its a weak motivational tool cuz u really dont have to slog as much…kinda goes along those lines… get it??