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Firms, like other economic organizations, serve to coordinate the actions of groups of people and to motivate them to carry out needed activities. The problem of motivating people in organizations comes from the fact that their own self-interest may not automatically lead them to act in the ways that the organization would want. This divergence of interests arises because the individual members of the organization typically do not bear all the costs and benefits of the actions they take and the decisions they make with the organization. Consequently, when they make decisions -- about how to spend their time, how hard to work and on what, what risks to take -- the choices that appear best from their personal point of view may not maximize the total value generated for the organization.

From an organization design perspective, the motivation problem is to shape the organization -- the people, the architecture, the routines and processes, and the culture -- to bring a closer alignment to interests between the organization and its members and thereby increase the efficiency of the choices they make.

The source and nature of motivation problems --
In general, motivation or incentive problems arise when individuals' organizational decisions and actions affect others in ways that the individual does not fully take into account -- when there are externalities. There are basically two ways a disparity can arise between the costs and benefits that an individual bears versus those that accrue to the organization as a whole.

  • Perhaps most often, individuals in organizations receive only a small fraction of the benefits that result from their taking various actions, but bear a disproportionate part of the costs that are involved. In this case, their decisions are likely to involve too little activity for organization efficiency.
  • The other possibility is that the fraction of the benefits that they get exceeds the share of costs that they bear. Then they are likely to choose too much of the activity in question.

Understanding why there are systematic divergences between the costs and benefits that accrue to the organization and those its decision makers face is the first step towards a solution. Contracts and reputations guide behavior in situations where interests differ and where the actions of one party have an impact on the well-being of others. (Roberts, 2004, pp 118-122)

If interests of the two parties are widely divergent to start with, contracts and reputations will very likely not serve to generate the proper motivation. Factors to consider preceding contracts and reputations is whether the values of the agent and principal align, as well as interests in a common purpose.