Bonuses and loss aversion

To motivate workers, organizations often offer monetary bonuses for meeting production goals. We develop a theoretical framework that predicts that when workers set production goals themselves and are sufficiently loss averse, bonuses lead to conservative goal setting, which worsens performance. Without a bonus, a loss-averse worker sets an ambitious goal to motivate herself through the aversion to falling short of the target. Tying a bonus to goal achievement crowds out this intrinsic motivation by raising the stakes of failure, leading to more cautious goals and lower performance. Empirical evidence from a laboratory experiment supports the predictions of our model. Our findings underscore the limits of bonuses when workers are loss averse.