Bonus and Penalty Schemes as Equilibrium Incentive Devices, with Application to Manufacturing Systems

This article reconciles the psychological notion of bonuses and penalties as incentive devices with an economic view of incentives. An objective definition of bonus and penalty schemes is presented and shown to correspond to equilibrium in a model of moral hazard and probabilistic monitoring. The model implies that middle-management and other nonproduction jobs are appropriate for bonus-type incentive contracts, whereas in either unskilled jobs or aspects of highly skilled jobs that require diligence but no skill, penalty incentive schemes are predicted. We argue that our model illuminates an internal contradiction in the prospect theory of Kahneman and Tversky. We also argue that Japanese manufacturing systems have inherent incentive properties that elicit a high level of diligence from factory workers. Copyright 1994 by Oxford University Press.