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When high-powered incentive contracts reduce performance: choking under pressure as a screening device

  • Bannier, Christina E.
  • Feess, Eberhard

Empirical and experimental papers find that high-powered incentives may reduce performance rather than improve it; a phenomenon referred to as choking under pressure. We show that competition for high ability workers nevertheless leads firms to offer high bonus payments, thereby deliberately accepting pressure-induced performance reductions. Bonus payments allow for a separating equilibrium in which only high ability workers choose high-powered incentive contracts. Low ability workers receive fixed payments and produce their maximum output which, however, is still below the reduced output of high ability workers. Bonus payments lead to a social loss which is increasing in the degree of competition. Our paper helps to explain why steep incentive schemes are persistent in highly-competitive industries such as investment banking, and why the observed performance sensitivity of CEO compensation is largely heterogeneous.

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Paper provided by Frankfurt School of Finance and Management in its series Frankfurt School - Working Paper Series with number 135.

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Date of creation: 2010
Date of revision:
Handle: RePEc:zbw:fsfmwp:135
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