When high-powered incentive contracts reduce performance: choking under pressure as a screening device
AbstractEmpirical and experimental papers find that high-powered incentives may reduce performance rather than improve it; a phenomenon referred to as choking under pressure. We show that competition for high ability workers nevertheless leads firms to offer high bonus payments, thereby deliberately accepting pressure-induced performance reductions. Bonus payments allow for a separating equilibrium in which only high ability workers choose high-powered incentive contracts. Low ability workers receive fixed payments and produce their maximum output which, however, is still below the reduced output of high ability workers. Bonus payments lead to a social loss which is increasing in the degree of competition. Our paper helps to explain why steep incentive schemes are persistent in highly-competitive industries such as investment banking, and why the observed performance sensitivity of CEO compensation is largely heterogeneous. --
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Bibliographic InfoPaper provided by Frankfurt School of Finance and Management in its series Frankfurt School - Working Paper Series with number 135.
Date of creation: 2010
Date of revision:
Performance-related pay; screening; choking under pressure; competition;
Find related papers by JEL classification:
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
- J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials
- J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-03-28 (All new papers)
- NEP-BEC-2010-03-28 (Business Economics)
- NEP-CTA-2010-03-28 (Contract Theory & Applications)
- NEP-LAB-2010-03-28 (Labour Economics)
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