Edward P. Lazear Stanford University

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Performance Pay: Lessons from Personnel

Economics

Compensation, Work Practices and Productivity

SteyrJuly, 2003

Edward P. Lazear Stanford University

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Today’s talk All pay is performance pay Traditional incentive pay

Uses - Sorting and incentives Results

Relative pay Intrinsic motivation

Edward P. Lazear Stanford University

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All Pay is Performance Pay Issue of structure and formula

Piece rates, commissions Hourly wages, annual salaries

Which variables determine best structure? Measurability Heterogeneity Complexity

Edward P. Lazear Stanford University

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Pay FormsPay on input or output?

Input• Hourly wage• Annual salary• Effort related bonuses

Output• Piece rates• Sales commissions• Output related bonuses• Team compensation

• Profit sharing• Stock and options

Edward P. Lazear Stanford University

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Input or Output? Measurement costs and risk aversion

Output sometimes difficult to measure• Complex• Teams• Takes time to play out (R&D)• Education (earnings)

• Proxies – Test scores Output highly variable (risky projects)

When risk or measurement is an issue, pay on input Input imperfect but often more available measure of

what is desired Input is non-distorting

Edward P. Lazear Stanford University

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Discrete or Continuous?

Compensation

Outputor effort

e*

W

0

Discrete

Continuous

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Both Create Incentives Discrete is strong in narrow range Continuous is weak in any one range,

but strong overall Not “high-powered” v. “low powered” Discrete well-suited to homogeneous

workforce Both induce sorting

Edward P. Lazear Stanford University

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Choice of Pay Structure

Continuous (Heterogeneous Workforce)

Discrete (Homogeneous or idiosyncratic workforce)

Input (Output difficult to observe)

Hourly wage paid management consultant

Retainer paid to a lawyer

Output (Output easy to observe)

Piece rate workers

Non-commission salesperson

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A European Issue Termination difficult Suggests use of continuous over

discrete

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An Example: Team Incentives European Oil Company

Oil field on Arctic Ocean – great success

Head office in Anchorage – total failure

The lesson Production versus managers? No Peer pressure effective small groups

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Results on “Performance Pay” for Managers Abowd (1990)

16,000 managers at 250 corporations Additional 10% performance 400 to 1200 basis

points on stock return Leonard (1990)

Companies with long-term incentive plans had significantly higher R.O.E.

Kaplan (1994) Japanese executives whose compensation is tied to

performance are associated with companies with higher subsequent performance

Almost never find the reverse

Edward P. Lazear Stanford University

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Managerial Performance Pay The “Puzzle”

If effective, why is the relation of pay to performance closer to zero than one?

• Jensen & Murphy, • Hall and Leibman• Graziano and Parigi (Italian firms have similar low elasticities)

Explanations Straw man

• Every manager cannot own firm• Groves and other mechanisms have problems

Enough incentives if managers are risk averse (Haubrich) Another reason for performance pay: Information for investors

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Put Your Money Where Your Mouth Is or “Skin in the Game”

Venture capitalists require low base + performance pay

Wage = a + b (Output) Incentive solution

b=1, a<0 Sorting solution: Homogeneous managers

b very small, a slightly less than alternative Always accepts positive profit project Never accepts never profit project

Much evidence for this view (new, high tech firms use more)

Edward P. Lazear Stanford University

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Another Form of Performance Pay: Tournaments

Almost all managers face implicit if not explicit tournaments

Tournament defined as pay or non-monetary compensation function of relative performance

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Tournaments Goal of tournament theory

To explain salary hierarchy To explain different patterns across industries

and countries Metaphor of tennis match

Compensation based on relative position The larger the spread, the more effort There is an optimal spread

• Too much variation creates recruitment and cooperation problems

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Mathematics

(W1 W2)g(0) C(µj)

a. qj µj εjb. qk µk εk

Maxµj

W1P W2(1 P) C(µj)

P Prob (µj εj>µk εk) Prob (µj µk>εk εj) G (µj µk)

(W1 W2)Pµj

C (µj) 0

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So… Bigger raises create greater

incentives Use larger spread in “noisier”

environments Higher wage differentials in new and/or

risky industries Higher wage differentials in US than in

Europe But bigger raises less teamwork

Edward P. Lazear Stanford University

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Evidence on Tournaments Eriksson (1999) finds strong support of

implied wage structure O’Reilly, Crystal and Main: Promotion

rates Sports: Ehrenberg and Bognano and later

Bronars, golf Experiments: Bull, Schotter and Weigelt

(1987) and Fehr and Falk (2002), Freeman, et. al. (2003), European Science Days students

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More Evidence on Tournaments Knoeber: Chickens Drago and Garvey (1998)

Large raises for promotionbetter attendance in 23 Australian firms

Large raises associated with less sharing

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Intrinsic and Extrinsic Action on the margin At some levels, makes no sense

Cut commissions so will work harder?

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A Traditional Human Resources View

The fundamental economic theory of motivation is based on assumptions of effort aversion (people will not expend effort unless paid to do so), opportunism (people, in the pursuit of their own interests, will often misrepresent their true preferences and engage in guile and deceit), and a lack of goal alignment (employees in organizations have different agendas than the owners and, therefore, incentive systems need to be designed to force people to do what is right for the good of the organization). In the economists’ view, people are assumed to be lazy, dishonest, and at odds with the goals of the managers.

Although each of these assumptions may be valid in a specific situation, or for a particular individual (for instance, when managing economists themselves), none is likely to be right in most settings with normal human beings.

- Charles O’Reilly and Jeffrey Pfeffer

Edward P. Lazear Stanford University

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Courses Taught

Salary

A

1 2 3 4 5

Equilibrium Number of Courses

An Example: Lazear’s Teaching

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Demand and Supply Version

Number of courses

WageLazear’s supply

Demand for Lazear courses

Intrinsic range

Extrinsic Range

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Conclusion Performance pay: Not whether but what form

Input or output Discrete or continuous Relative or absolute

Output-based performance pay may be as important for selection as incentives

Rank-order based incentives are pervasive for managers Manifestations

• Promotions• Bonuses• Status and other non-monetary factors

Adverse effects on cooperation Implicit if not explicit almost everywhere so understanding

essential