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Output-based Pay: Incentives or Sorting?

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  • Edward P. Lazear

Abstract

Variable pay, defined as pay that is tied to some measure of a firm's output, has become more important for executives of the typical American firm. Variable pay is usually touted as a way to provide incentives to managers whose interests may not be perfectly aligned with those of owners. The incentive justification for variable pay has well-known theoretical problems and also appears to be inconsistent with much of the data. Alternative explanations are considered. One that has not received much attention, but that is consistent with may of the facts, is selection. Managers and industry specialists may have information about a firm's prospects that is unavailable to outside investors. In order to induce managers to be truthful about prospects, owners may require managers to 'put their money where their mouths are,' forcing them to extract some of their compensation in the form of variable pay. The selection or sorting explanation is consistent with the low elasticities of pay to output that are commonly observed, with the fact that the elasticity is higher in small and new firms, and with the fact that variable pay is more prevalent in industries with very technical production technologies. It does not explain why some firms give stock options even to very low-level workers.

Suggested Citation

  • Edward P. Lazear, 1999. "Output-based Pay: Incentives or Sorting?," NBER Working Papers 7419, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:7419
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    Cited by:

    1. Bergman, Nittai K. & Jenter, Dirk, 2007. "Employee sentiment and stock option compensation," Journal of Financial Economics, Elsevier, vol. 84(3), pages 667-712, June.
    2. Jaag, Christian, 2006. "Teacher Incentives," MPRA Paper 340, University Library of Munich, Germany.
    3. William Fuchs, 2007. "Contracting with Repeated Moral Hazard and Private Evaluations," American Economic Review, American Economic Association, vol. 97(4), pages 1432-1448, September.
    4. Fredrik Andersson & Matthew Freedman & John Haltiwanger & Julia Lane & Kathryn Shaw, 2009. "Reaching for the Stars: Who Pays for Talent in Innovative Industries?," Economic Journal, Royal Economic Society, vol. 119(538), pages 308-332, June.
    5. Bushman, Robert M. & Smith, Abbie J., 2001. "Financial accounting information and corporate governance," Journal of Accounting and Economics, Elsevier, vol. 32(1-3), pages 237-333, December.
    6. Quigley, Neil & Hortsmann, Ignatius & Mathewson, Frank, 2005. "Agency Contracts with Long-Term Customer Relationships," Working Paper Series 3850, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    7. Weiyi Zhang & Hiromasa Takahashi & Junyi Shen, 2016. "Does Physical Exercise Affect Tradeoffs between Fixed Pay and Performance-related Pay for Individuals?," Discussion Paper Series DP2016-13, Research Institute for Economics & Business Administration, Kobe University.
    8. Origo, Federica, 2009. "Flexible pay, firm performance and the role of unions. New evidence from Italy," Labour Economics, Elsevier, vol. 16(1), pages 64-78, January.
    9. Campbell, Benjamin A., 2003. "Firm Volatility and Stock Option Incidence," Institute for Research on Labor and Employment, Working Paper Series qt7gt1r0pn, Institute of Industrial Relations, UC Berkeley.
    10. Chinhui Juhn & Kristin McCue & Holly Monti & Brooks Pierce, 2015. "Firm Performance and the Volatility of Worker Earnings," NBER Chapters,in: Firms and the Distribution of Income: The Roles of Productivity and Luck National Bureau of Economic Research, Inc.
    11. Arindrajit Dube & Richard B. Freeman, 2010. "Complementarity of Shared Compensation and Decision-Making Systems: Evidence from the American Labor Market," NBER Chapters,in: Shared Capitalism at Work: Employee Ownership, Profit and Gain Sharing, and Broad-based Stock Options, pages 167-199 National Bureau of Economic Research, Inc.
    12. Edward P. Lazear, 2004. "Salaire à la performance : incitation ou sélection," Économie et Prévision, Programme National Persée, vol. 164(3), pages 17-25.
    13. Pierre Malgrange & Jean-Louis Rullière & Marie Claire Villeval, 2004. "L'économie des ressources humaines : pouvoir et limites des incitations. Aperçu théorique et présentation générale," Economie & Prévision, La Documentation Française, vol. 0(3), pages 1-15.
    14. Kshitija Dixit & Rupayan Pal, 2010. "The impact of group incentives on performance of small firms: Hausman-Taylor estimates," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 31(6), pages 403-414.

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    JEL classification:

    • J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs

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