Optimal Loyalty‐Based Management

• Published date: 01 June 2017
• Date: 01 June 2017
• DOI: http://doi.org/10.1111/jems.12194
• Author: Dongsoo Shin

Optimal Loyalty-Based Management

DONGSOO SHIN

Department of Economics, Leavey School of Business

Santa Clara University

Santa Clara CA 95053

dshin@scu.edu

We study an agency model in which an entrepreneur selects a manager from a candidate set.

The selected manager’s effort improves the project’s potential environment, and is a hidden

action. The realized project environment is the entrepreneur’s private information. A manager’s

utility has two components—(i) loyalty, with which the manager values the organization’sprofit,

and (ii) selfishness, with which the manager values the monetary transfer he receives from the

entrepreneur.We find that if the manager’s task is easy enough, it is optimal to use a purely loyal

manager. Otherwise, it can be optimal to use a manager with mixtureof loyalty and selfishness—

the manager’s mixed motivation alleviates the entrepreneur’s misrepresenting incentive, and as

a result, the output distortion in the optimal contract can be reduced. In addition, when it is

optimal to use a manager with mixed motivations, the entrepreneur selects someone who is more

selfish than loyal.

1. Introduction

It has long been emphasized by studies of human resource management that using an

employee with the right motivation for the job not only affects the employee’s produc-

tivity, but also impacts on the organization’s overall performance.1As noted by various

studies in organizational economics and agency theory,efficiency gains often arise from

having loyal employees who share their employers’ preferences.2The benefit of having

employees who value their organization’s achievement without extrinsic rewards has

also been recognized and stressed in management studies, as well as psychology and

sociology.3

Despite the benefits of having loyal employees who are intrinsically motivated

for their organization’s success, not all practitioners report about positive aspect of

employee loyalty. In the New York Times, for example, Schwartz (2015) points out that

organizations can use loyal and engaged employees most effectively when work loads

are not too heavy. Otherwise, according to Schwartz, such employees may not be those

from whom the organizations can benefit the most. Similarly, Glenner (2013) reports

that using selfish employees can sometimes be the most efficient way to get jobs done

if the organizations provide them with the right incentives so that such employees can

harness their selfish motivation.

I am grateful to the co-editor and two anonymous referees for valuable comments and suggestions. I also thank

the seminar participants at FGV-EPGE, ESSEC Business School, University of Cergy-Pontoise (THEMA), and

IIOC at Drexel University for comments and discussions.

1. See Baron and Kreps (1999) for example.

2. See Holmstrom and Milgrom (1991), Fey (1997), Gibbons (1998), Prendergast (1999, 2007), Benabou and

Tirole (2003, 2016), Akerlof and Kranton (2005), Besley and Ghatak (2005) among others.

3. See Kruglanski et al. (1971), Deci (1975), and Sweetman (2001), for example.

C2016 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume26, Number 2, Summer 2017, 429–453

430 Journal of Economics & Management Strategy

In this paper, we demonstrate that organizations may not always benefit from us-

ing loyal employees for their tasks. Tobe more specific, our study answers the following

question. Under what circumstances would organizations benefit more from using loyal

employees who value the organization’s achievement, or selfish employees who value

extrinsic rewards? Motivation factors that drive different types of employee have been a

subject of discussion for long time, and although there are studies in organizational sci-

ence and management that consider the pros and cons of hiring strongly self-motivated

employees,4few economic studies have demonstrated the trade-offs between using loyal

and selfish employees.5

In an agency model, we identify the optimal degree to which an organization’s

management is based on employee loyalty. In doing so, we provide an economic ra-

tionale for judging when using employees with strong loyalty to the organization is

advantageous or disadvantageous, and why this is so. Our result is as follows. For a

sufficiently easy task, it is optimal to use a loyal employee who only cares about the

organization’s profit. When the task is not so easy, however, it can be optimal for the

organization to use someone with a mixture of loyalty and selfishness. Moreover, when

it is optimal to benefit from an employee’s mixed motivations, the selected employee is

more selfish than loyal.

In our model, an entrepreneur uses a manager to improve the potential project

environment (the project’s profitability). The manager’s effort is hidden action, and

the realized project environment is the entrepreneur’s private information. It is well

documented that entrepreneurs or top managements are better informed on project en-

vironments than the rest of their organizations. Their experiences and networks, as noted

by Mintzberg (1973, 1983), provide them with comprehensive and better access to both

external and internal information. Weview the entrepreneur as the project designer, who

has better information about the project environment. In our paper, the entrepreneur’s

incentive to manipulate her private information interplays with the manager’s shirking

incentive.

The manager used for the task is selected from a set of candidates with different

mixes of two motivational components—loyalty and selfishness. With loyalty, the man-

ager values the project’s profit, whereaswith selfishness, he values the monetary transfer

that he receives in return for his effort. There is a continuum of types of a manager’s

motivation, ranging from the purely loyal type to the purely selfish type. At the outset,

the entrepreneur selects a manager of a certain type, and makes an offer to him.

When the manager’s task is sufficiently easy (i.e., the cost of effort is lower than a

threshold level), the purelyloyal manager will not shirk, and hence the entrepreneur does

not need to manipulate the contractual variables to induce the manager’s effort. In such a

case, the entrepreneur has no incentive to misrepresent the realized projectenvironment

(as mentioned above, the manager’s shirking incentive interacts with the entrepreneur’s

misrepresenting incentive). As a result, when the task is easy enough, using the purely

loyal manager enables the entrepreneur to achieve the first-best outcome—that is, the

schedule of optimal project size, represented by the output schedule, is undistorted.

As the task becomes harder, however, the purely loyal manager’s incentive to

shirk becomes an issue. Because the manager of this type values only the project’s profit,

inducing his effort requires the project’s ex post profit to increase more sharply in the

project environment. With such an arrangement, however, the entrepreneur may have

4. See Argyris (1998), Osterloh and Frey (2000), and Fischer (2004), for example.

5. Exceptions are Prendergast (2008) and Makris and Sicilini (2013).