Pay for performance

• Motivation – Intrinsic (interested in the job as such) – Extrinsic motivation

• Pay • Work environment, non-pay characteristics, benefits

• Inefficient to rely on intrinsic motivation only – Workers and jobs can vary a lot w.r.t. intrinsic

motivation

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Open questions

• How to measure performance? • What is the principle-agent problem? • Risk associated with performance-related

pay • What bias if measurement of performance is

too narrow?

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Principle Agent Problem

• Principal: Firm owner, Manager • Agent: Worker

– (similar case for Firm owner-Manager relation)

• Goals of principal and agent are not identical – Principal wants to maximize value of the firm Q,

(Q(E), influenced by effort E of worker)

– Worker wants to maximize pay • Pay determined by measured performance MP, Pay(MP) • MP=Q + ε, ε is measurement error

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Principle Agent Problem

• Marginal revenue of more effort E – For principal: 𝜕𝜕𝑄𝑄 𝜕𝜕𝜕𝜕�

– For agent: 𝜕𝜕𝑃𝑃𝑃𝑃𝑃𝑃𝜕𝜕𝜕𝜕

= 𝜕𝜕𝑃𝑃𝑃𝑃𝑃𝑃𝜕𝜕𝜕𝜕𝑃𝑃

𝜕𝜕𝜕𝜕𝑃𝑃𝜕𝜕𝜕𝜕

– If marginal return for agent lower as for

principal ==> agent exerts too little effort – Q and MP not identical (measurement error)

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Measurement issues

• Measurement of performance of the worker in the firm Q=Q(E)

• Output- or input-based – Output: measure Q (sales, share price, costumer satisfaction, …)

• Broad measure: Q • Narrow measure: only a part of Q

– Input-based: E (effort, working hours, number of jobs done, …)

• Quantitative or qualitative evaluation – Quantitative: accounting figures, … – Qualitative: evaluation by supervisor (subjective) – Ordinal measurement: promotion tournament

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Risk

• Uncontrollable risk: variation in measured performance (MP), the worker cannot control (business cycle, rain, other workers, rivals,…) – Performance pay is rewarding lucky outcomes – Risk-averse workers need to be compensated for that by higher

base pay – More narrow measurement less risk

• Controllable risk: if the worker works harder, pay rises – No problem for worker, because under her own control – Better a broader measurement of performance, because all aspects

of performance are captured

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Performance-related pay

• University Professors get a straight salary – which is not even based on age (may be considered high or low, depending on your point of view).

• Should we introduce incentive pay, e.g. by # of exams or scientific papers written?

• What are the tasks of academics? • What are problems of incentive pay?

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Variable pay or straight salary

• Pay by Output = Incentive Pay – Agricultural workers (piece rate) – Salespeople (straight commission) – Top executives (stocks as part of compensation)

• Pay by Input Depends on effort spent on an activity, time =

proxy for input, effort

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Effects of incentive pay

• 1. Selection: good workers stay, bad

workers leave

• 2. Incentives: workers put more effort into work

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1. Selection

• Positive influence on hiring and retention – low ability workers

will look for jobs that pay by input rather than output

– workers who do not want to work hard are likely to leave the firm.

If you can sell > 5, you go to the company with output based pay. If < 5 you go to the flat base pay

Wee

kly

Pay

Number of encyclopedias sold

500

5

$100/sale

Flat rate=$500/week

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2. Incentives

• How to set an optimal incentive scheme? Example: taxi drivers

• Scheme A: Driver rents the car, pays for gas and keeps all revenues (commission rate = 100%)

e.g. compensation = - €100 + € 2*(km driven) – gasoline expense

• Scheme B: Company provides driver with the cab, pays for gas and they split the revenues 50:50 („revenue splitting“)

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Problems with Scheme B

• Moral hazard of driver switch off meter (monitoring

difficult!)

• Suboptimal effort goes home too early

• Adverse selection Here also: only less able or

less hard-working are attracted

Compensation

Output - 100

Q*

Scheme A

Scheme B

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Deriving the optimal compensation scheme

• Assumptions: – Output of worker depends only on effort E – Worker is averse to effort E,

• Disutility of effort E is C(E) • Effort costs rise disproportionally (concave)

– No risk aversion of agent (= no risk/uncertainty involved)

• Goal: – How to set an optimal compensation scheme that maximizes firm‘s profits? Eα +β

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The worker‘s considerations

• How does the worker choose effort optimally – to max her utility:

where is the worker‘s total compensation • First order condition:

• ==> put so much effort into work until marginal effort cost equals the marginal return for effort

EMax E C(E)α+β −

C'(E) = 0E

C'(E)

∂= β−

∂β =

Eα +β

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How does the firm choose wage schedule: a and b ?

• Firm chooses a and b to maximize profits, but has two constraints:

– Choice of b will determine Effort E (previous slide) – Total compensation must be high enough to keep the

worker with the firm, i.e.

• Net revenue is defined as E, firm maximizes:

• First order condition:

* *E C(E )α +β ≥

Max E - - E = E - C(E)β

α β

( ) E1 C'(E) 0 1 = C'(E) = ∂− = ⇒ β

∂β

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Surprising result: worker should get the whole additional output!

• b = 1: Worker should act as „residual claimant“ – should act like an entrepreneur. Only this contract will allow the optimal choice of effort! --- think about the taxi example!

• How does the firm make profit in this case? chooses a as low as possible, but so that worker is still

willing to sign the contract! Select a so that: typically negative!

* *E C(E )α + =

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Example: salesperson‘s commission

• Marginal costs for computer €900 • Market price €1000 • What is the optimal commission per piece?

As a percentage of sales?

• Solution seems optimal for the worker, but is this really optimal for the firm?

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Example: salesperson‘s commission

• Profit for the firms comes from rental fee of the job (desk)

• Again: Why not simply lower commission rate? Input of effort would be inefficient, total

output inefficiently small!

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The „reality-question“!

• Principle idea: 100% commission rate, and worker has to pay for having the job.

• Why don‘t you see workers paying for their jobs very often?

• Often no explicit payment, but implicit

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„Paying“ for the job

• Is it better to have, say, 10% in sales or 100% in profits? – Moral hazard on the side of the firm!

• Consider the 100 percent commission of the taxi driver. Does this scheme solve all incentive problems? – Who cares for maintenance of the car?

– Capital market imperfections do not allow buying the firm, which would sometimes be the best solution to maintenance problems.

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Advantages of time-based pay

• Cost advantage in measurement

• Quantity versus Quality – How can quality checks be done? – Quality more difficult to measure – Is it enough to check random sample?

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Disadvantage of piece rate: Sometimes output does not only depend on effort – causes risk for

worker!

• Sometimes (always) variations in output are beyond the worker’s control (business cycle, …)

• Payment by output: worker suffers from economic downturns, benefits from boom.

• Here: Output Q=E+ε, with ε as a random variable

• Wage schedule: – W = α + βQ = α + β(E+ε)

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Risk aversion of workers

• Usually workers are risk averse, their liabilities (food, housing, clothing etc.) are relatively fixed, variations in income generate difficulties.

– Define risk aversion!

• Firms are usually more risk neutral, can diversify risk across investments.

• 1st principle of optimal insurance: the party who can more easily absorb risk (i.e. the party that is most risk neutral) should insure the other party.

– If the firm accepts to bear the risk it can pay lower wages.

– Trade-off: insurance reduces worker’s incentives!

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Size of incentives – setting b when b = 1 not possible (risk aversion)

• The lower the risk aversion among workers, the higher the incentives should be.

• The higher the ability of workers, the stronger the incentives should be.

• The stronger the effect of increased effort by the employee on company profits, the greater the incentives should be.

• The stronger the impact of incentive on effort, the greater the incentives should be.

• The greater the precision of output measurement, the greater the incentives should be.

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Measurement of output

– Sometimes output is of a kind that is simply unmeasurable.

– If variations in output are due to external factors that are not controllable by the employee it is difficult to measure effort.

– If the work of the employee depends upon coordination with other employees, it may be difficult to single out their individual contribution. It may be necessary to pay on a team basis.

– There may be multiple tasks. Incentives must be balanced across different tasks. If it is difficult to measure the performance on task A, strong incentives on other tasks will result in the employee ignoring task A.

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Equal Compensation Principle

• If the worker has two tasks, either compensate effort alike in both, or don‘t use incentive contracts

– E.g. University professors do teaching and research

• Similar problems: – Quantity versus quality – Short run and long run incentives

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Difficulties when setting a piece rate

• Management has the incentive to increase the required level of production when the workers easily surpass their old levels.

• This is called the ratchet effect. • Workers earn profit for extra effort only for one period, in the next the

gains are taken away by the firm. • Since workers realize that the ratchet effect exists, they will be

reluctant to work to their full capacities in the first period or they may try to force other workers to slow down. (Interests of stayers versus leavers.)

• ==> make long-term contracts with commitment not to change piece rate schedule

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Different types of pay-performance payment

• Output based measures often involve quotas, bonus payments, caps or promotions.

• What are the advantages, disadvantages of these schemes?

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Application: Safelite Glass

• Largest installer of automobile glass in US

• Until 1994 glass installers were paid hourly wage rate

• Then shift to piece-rate schedule, pay per number of glass units installed

• Computerized information system: no measurement costs

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Indifference curves of workers

– Individual is indifferent to putting more effort into work if sufficiently compensated

– Upward sloping because output requires effort which is painful („bad“)

– Utility increases to the northwest – Convex because for greater levels of efforts

worker demands even larger compensation for increased effort (closer to exhaustion)

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Two types of workers

– Type A doesn‘t like to work: He has to be paid

a lot so he is prepared to put in additional effort.

– Type B doesn‘t have such a strong distaste against work. For a little compensation she is willing to work harder.

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Choice of effort by workers straight salary

If workers are paid by time and the minimum acceptable standard of effort is e0, than both types of workers will choose an effort of exactly e0.

But: some workers might actually be willing to work significantly harder for only slightly higher pay!

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Predictions of theory when switching to piece rates

Switching to piece rates...

– ... leaves some individuals‘ behavior (those less able/less motivated) unaltered. These are equally well of as before.

– ... increases the effort of others (those more able/more motivated). Thus, average effort rises. Satisfaction of this group also rises.

– Since higher ability workers now find the firm relatively more attractive, average ability rises.

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Empirical findings at Safelite Glass Corporation

• Switch from salaries to piece rates induced a 36% increase in productivity.

• 2 Effects: – Effort Effect: 20 % due to incentives: Given worker

produces 20 % more after switch to piecework. – Sorting Effect: 16 % are due to changing composition

of the workforce: more high-quality types attracted

• Pay increased by 9%

(Based on Lazear, E.P., Performance pay and productivity, American Economic Review, 2000, 1346-1361)

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Safelite Glass Corporation: Some additional remarks

• Quality problems: Replacement of broken or leaking windshilds by installer on own time

• Measurement: Computerized • Competition: Other firms will copy

switching to piecework if profitable. But in the meantime Safelite Glass Corporation can make higher profits.

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Bonuses or penalties

• Consider 2 different job offers: – Scheme A pays €10,000 per month plus a bonus of €1

for every unit sold – Scheme B pays €15,000 per month with a 5,000 unit

quota: penalizing the worker with €1 for every unit below the quota

– To make it simple: suppose it‘s not possible to produce more than 5,000.

• What is more attractive for workers? • Which job offer creates the highest incentives?

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Bonuses or penalties

• Psychological considerations: – „only use positive rewards“ – Theory of loss aversion (Kahneman and Tversky):

experiments showing that people hate to give up something they feel they own.

• Economic considerations: – Use bonus when there is no cost to poor performance – Use penalty if there is no benefit to high performance – Examples?

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Penalty or Bonus

• Bonus – Base pay for regular work – Insurance character: worker typically worried whether

she might end up with very low pay – Workers will take more risks, star jobs

• Penalty – Low incentive after threshold level – Guardian jobs (negligence is costly for the firm, but no

upward potential

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