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You Don't Always Get What You Pay For: Bonuses, Perceived Income and Effort

  • Wendelin Schnedler

Consider a principal-agent relationship in which more effort by the agent raises the likelihood of success. This paper provides conditions such that no success bonus induces the agent to exert more effort and the optimal contract is independent of success. Moreover, success bonuses may even reduce effort and thus the probability of success. The reason is that bonuses increase the perceived income of the agent and can hence reduce his willingness to exert effort. This perceived income effect has to be weighed against the incentive effect of the bonus. The trade-off is determined by the marginal effect of effort on the success probability in relation to this probability itself (success hazard-rate of effort). The paper also discusses practical implications of the finding.

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File URL: http://hdl.handle.net/10.1111/j.1468-0475.2010.00508.x
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Article provided by Verein für Socialpolitik in its journal German Economic Review.

Volume (Year): 12 (2011)
Issue (Month): 1 (02)
Pages: 1-10

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Handle: RePEc:bla:germec:v:12:y:2011:i:1:p:1-10
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  1. Bengt Holmstrom, 1997. "Moral Hazard and Observability," Levine's Working Paper Archive 1205, David K. Levine.
  2. Thiele, Henrik & Wambach, Achim, 1999. "Wealth Effects in the Principal Agent Model," Journal of Economic Theory, Elsevier, vol. 89(2), pages 247-260, December.
  3. Michael Kosfeld & Armin Falk, 2006. "The Hidden Costs of Control," American Economic Review, American Economic Association, vol. 96(5), pages 1611-1630, December.
  4. Friebel, Guido & Schnedler, Wendelin, 2007. "Team Governance: Empowerment of Hierarchical Control," IDEI Working Papers 520, Institut d'Économie Industrielle (IDEI), Toulouse.
  5. Bruno S. Frey & Reto Jegen, 2000. "Motivation Crowding Theory: A Survey of Empirical Evidence," CESifo Working Paper Series 245, CESifo Group Munich.
  6. Wendelin Schnedler & Radovan Vadovic, 2011. "Legitimacy of Control," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 20(4), pages 985-1009, December.
  7. Schnedler, Wendelin, 2002. "The virtue of being underestimated: a note on discriminatory contracts in hidden information models," Economics Letters, Elsevier, vol. 75(2), pages 171-178, April.
  8. Sliwka, Dirk, 2003. "On the Hidden Costs of Incentive Schemes," IZA Discussion Papers 844, Institute for the Study of Labor (IZA).
  9. Amin H. Amershi & John S. Hughes, 1989. "Multiple Signals, Statistical Sufficiency, and Pareto Orderings of Best Agency Contracts," RAND Journal of Economics, The RAND Corporation, vol. 20(1), pages 102-112, Spring.
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