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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://www.bristol.ac.uk/cmpo/publications/papers/2009/wp226.pdf
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Paper provided by Department of Economics, University of Bristol, UK in its series The Centre for Market and Public Organisation with number 09/226.

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Length: 13 pages
Date of creation: Nov 2009
Date of revision:
Handle: RePEc:bri:cmpowp:09/226
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  1. Guido Friebel & Wendelin Schnedler, 2007. "Team Governance: Empowerment or Hierarchical Control," Working Papers 0457, University of Heidelberg, Department of Economics, revised Oct 2007.
  2. Bruno S. Frey & Reto Jegen, 2000. "Motivation Crowding Theory: A Survey of Empirical Evidence," CESifo Working Paper Series 245, CESifo Group Munich.
  3. Schnedler, Wendelin, 2001. "The Virtue of Being Underestimated: A Note on Discriminatory Contracts in Hidden Information Models," IZA Discussion Papers 342, Institute for the Study of Labor (IZA).
  4. 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.
  5. Wendelin Schnedler & Radovan Vadovic, 2007. "Legitimacy of Control," Working Papers 0450, University of Heidelberg, Department of Economics, revised Aug 2007.
  6. HOLMSTROM, Bengt, . "Moral hazard and observability," CORE Discussion Papers RP -379, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  7. Thiele, Henrik & Wambach, Achim, 1999. "Wealth Effects in the Principal Agent Model," Journal of Economic Theory, Elsevier, vol. 89(2), pages 247-260, December.
  8. Michael Kosfeld & Armin Falk, 2006. "The Hidden Costs of Control," American Economic Review, American Economic Association, vol. 96(5), pages 1611-1630, December.
  9. Sliwka, Dirk, 2003. "On the Hidden Costs of Incentive Schemes," IZA Discussion Papers 844, Institute for the Study of Labor (IZA).
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