Performance Pay

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
Personnel Economics 5 1
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?
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 + , is measurement error
Principle Agent Problem
Marginal revenue of more effort E

For principal:

For agent: =

Marginal return for agent lower as for principal

==> agent exerts too little effort
Q and MP not identical (measurement error)
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
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
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?
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
Effects of incentive pay
1. Selection: good workers stay, bad

workers leave
2. Incentives: workers put more effort into

work
1. Selection
Positive influence on
hiring and retention
Weekly Pay
low ability workers $100/sale
will look for jobs that 500
pay by input rather Flat rate=$500/week
than output 5
workers who do not Number of encyclopedias sold
want to work hard If you can sell > 5, you go to

are likely to leave the the company with output based
pay. If < 5 you go to the flat
firm. base pay
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*(miles driven) gasoline expense
Scheme B: Company provides driver with the cab,

pays for gas and they split the revenues 50:50
(revenue splitting)
Problems with Scheme B
Moral hazard of driver

switch off meter (monitoring
difficult!) Compensation
Suboptimal effort
goes home too early Scheme A
Scheme B
Adverse selection
Here also: only less able or
less hard-working are Q* Output
- 100
attracted
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)
No risk/uncertainty involved
Goal:
How to set an optimal compensation scheme
+ E that maximizes firms profits?
The workers considerations
How does the worker choose effort optimally to max her
utility:
Max + E C(E)
E
where + E is the workers total compensation

First order condition: = C '(E) = 0
E
= C '(E)
==> put so much effort into work until marginal effort cost
equals the marginal return for effort
How does the firm choose wage
schedule: and ?
Firm chooses and to maximize profits, but has two
constraints:
Choice of will determine Effort E (previous slide)
Total compensation must be high enough to keep the
worker with the firm, i.e. + E* C(E* )
Net revenue is defined as E, firm maximizes:
Max E - - E = E - C(E)

First order condition:
E
(1 C '(E) ) = 0 1 = C'(E) =

Surprising result: worker should get the
whole additional output!
= 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 as low as possible, but so that worker is still
willing to sign the contract!
Select so that: + E* = C(E* )
typically negative!
Example: salespersons
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?
Example: salespersons
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!
The reality-question!
Principle idea: 100% commission rate, and

worker has to pay for having the job.
Why dont you often see workers paying for

their jobs?
Often no explicit payment, but implicit
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.
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?
Disadvantage of piece rate: Sometimes output
does not only depend on effort causes risk for
worker!
Sometimes (always) variations in output are
beyond the workers control (business cycle, )
Payment by output: worker suffers from economic
downturns, benefits from boom.
Here: Output Q=E+, with as a random variable
Wage schedule:
W = + Q = + (E+)
Risk aversion of workers
Usually workers are risk averse, their liabilities (food, housing,

clothing etc.) are relatively fixed, variations in income generate
difficulties.
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 workers incentives!
Size of incentives setting
when = 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.
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.
Equal Compensation Principle
If the worker has two tasks, either compensate

effort alike in both, or dont use incentive
contracts
E.g. University professors do teaching and research
Similar problems:
Quantity versus quality
Short run and long run incentives
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
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?
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
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)
Two types of workers
Type A doesnt like to work: He has to be paid

a lot so he is prepared to put in additional
effort.
Type B doesnt have such a strong distaste
against work. For a little compensation she is
willing to work harder.
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!
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.
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)
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.
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 its not possible to produce
more than 5,000.
What is more attractive for workers?
Which job offer creates the highest incentives?
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?
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

Performance Pay

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Performance Pay

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Pay for performance

Inefficient to rely on intrinsic motivation

How to measure performance?

Principal: Firm owner, Manager

Marginal revenue of more effort E

Marginal return for agent lower as for principal

Measurement of performance of the worker in the firm

Uncontrollable risk: variation in measured performance

University Professors get a straight salary which

1. Selection: good workers stay, bad

2. Incentives: workers put more effort into

will look for jobs that 500

pay by input rather Flat rate=$500/week

workers who do not Number of encyclopedias sold

want to work hard If you can sell > 5, you go to

How to set an optimal incentive scheme?

Scheme A: Driver rents the car, pays for gas and

Scheme B: Company provides driver with the cab,

Moral hazard of driver

where + E is the workers total compensation

= 1: Worker should act as residual claimant should

How does the firm make profit in this case?

Solution seems optimal for the worker, but

Input of effort would be inefficient, total

Principle idea: 100% commission rate, and

Why dont you often see workers paying for

Often no explicit payment, but implicit

Is it better to have, say, 10% in sales or 100% in profits?

Consider the 100 percent commission of the taxi driver.

Cost advantage in measurement

Quantity versus Quality

Usually workers are risk averse, their liabilities (food, housing,

Sometimes output is of a kind that is simply unmeasurable.

If the worker has two tasks, either compensate

Management has the incentive to increase the required level of

Output based measures

What are the advantages,

Largest installer of automobile glass in US

Individual is indifferent to putting more effort

Type A doesnt like to work: He has to be paid

But: some workers might actually be willing to

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