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The welfare effects of incentive schemes

  • Adam Copeland
  • Cyril Monnet

This paper computes the change in welfare associated with the introduction of incentives. Specifically, we calculate by how much the welfare gains of increased output due to incentives outweigh workers' disutility from increased effort. We accomplish this by studying the use of incentives by a firm in the check-clearing industry. Using this firm's production records, we model and estimate the worker's dynamic effort decision problem. We find that the firm's incentive scheme has a large effect on productivity, raising it by 14% over the sample period. Using our parameter estimates, we show that the cost of increased effort due to incentives is equal to the dollar value of a 9% rise in productivity. Welfare is measured as the output produced minus the cost of effort, hence the net increase in welfare due to the introduction of the firm's bonus plan is 5%. Under a first-best scheme, we find that the net increase in welfare is 6%.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2003-08.

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Date of creation: 2003
Date of revision:
Handle: RePEc:fip:fedgfe:2003-08
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  1. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
  2. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
  3. Margiotta, Mary M & Miller, Robert A, 2000. "Managerial Compensation and the Cost of Moral Hazard," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 41(3), pages 669-719, August.
  4. J. H. Abbring & P.-A. Chiappori & J. J. Heckman & J. Pinquet, 2002. "Testing for Moral Hazard on Dynamic Insurance Data," THEMA Working Papers 2002-24, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
  5. repec:oup:restud:v:66:y:1999:i:2:p:309-38 is not listed on IDEAS
  6. Goffe, William L. & Ferrier, Gary D. & Rogers, John, 1994. "Global optimization of statistical functions with simulated annealing," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 65-99.
  7. repec:oup:qjecon:v:113:y:1998:i:1:p:149-185 is not listed on IDEAS
  8. Ariel Pakes, 1984. "Patents as Options: Some Estimates of the Value of Holding European Patent Stocks," NBER Working Papers 1340, National Bureau of Economic Research, Inc.
  9. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January.
  10. Pierre André Chiappori & Bernard Salanié, 2002. "Testing Contract Theory: A Survey of Some Recent Work," CESifo Working Paper Series 738, CESifo Group Munich.
  11. Edward P. Lazear, 2000. "Performance Pay and Productivity," American Economic Review, American Economic Association, vol. 90(5), pages 1346-1361, December.
  12. Rust, John, 1987. "Optimal Replacement of GMC Bus Engines: An Empirical Model of Harold Zurcher," Econometrica, Econometric Society, vol. 55(5), pages 999-1033, September.
  13. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
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