Incentive pay, managerial skills and span of control

The use of incentive pay to elicit worker effort is a hallmark of agency theory. Although an extensive literature has investigated the effects of these incentives on both firm and worker performance, less attention has been paid to their heterogeneous use across firms. We document that incentive contracts are more likely adopted in firms with better educated managers and with hierarchies where the span of control is larger. This result is robust to different specification models that account for selectivity effects, measurement errors, heterogeneity in the type of incentive pay and the incidence of teamwork. We rationalize this empirical evidence through a simple principal-(multi)-agent model where a manager optimally allocates her time across two tasks: coordination and supervision. The model hinges on two assumptions: first, the marginal benefit of coordination is assumed increasing in the managers’ skills. Second, the marginal benefit of supervision is assumed decreasing in the manager’s span of control. With these ingredients the model suggests that managers who are more skilled and having larger span of control should focus more on coordination and less on supervision, and thus, pay higher bonuses to elicit labour effort. Taken together, these results help to extend the debate about the drivers of incentive pay beyond standard worker and industry-level characteristics, and to focus more explicitly on firm and manager features instead.