Tuesday, May 05, 2009

From the archive: Pay enough or not at all

One more post on principal-agent incentives. The use of carrots to solve such problems rests on the assumption that people respond to the incentive offered by increasing effort. In standard economics, any positive incentive should, at the margin, improve effort. In practice, though, this may not be true. Some evidence suggests that offering monetary incentives can actually reduce effort.

Following up on the earlier post on the fact that monetary incentives might lead to worse outcomes, a paper by Uri Gneezy and Aldo Rustichini further confirms that monetary incentives can actually reduce performance. However, they also find that larger monetary incentives do increase performance. The paper can be found here. Here is the abstract:

Economists usually assume that monetary incentives improve performance, and psychologists claim that the opposite may happen. We present and discuss a set of experiments designed to test these contrasting claims.

We found that the effect of monetary compensation on performance was not monotonic. In the treatments in which money was offered, a larger amount yielded a higher performance. However, offering money did not always produce an improvement: subjects who were offered monetary incentives performed more poorly than those who were offered no compensation. Several possible interpretations of the results are discussed.

Their results are based on two experiments. In the first experiment, students answered questions on a test which largely tested effort. All students were promised a fixed payment for participation; however, some students were paid an additional sum based on the number of questions they answered correctly. One group was given 10 cents per correct answer, another $1 per correct answer, and another $3 per correct answer. The group getting 10 cents per correct answer performed significantly worse than the group not getting any additional payment (and this group did worse then the $1 and $3 groups).

In the second experiment, the researchers introduced incentives to a public service day which occurs regularly in Israel. Apparently, certain days during the year students take to the streets to collect donations for various causes. Three groups of students were studies. In one group, no additional incentives were introduced. In another group students received 1 percent of what they raised. And in the other group they received 10 percent of what they raised. In both of the treatment groups it was made clear that the money was being paid by the researchers and was not coming out of the money that was being raised. Again, the no treatment group out performed the small incentive group, and in this experiment they equaled the high treatment group.

I think these studies can relate to labor markets; I do think it is likely that workers who are offered bonuses for effort could end up not improving effort or even lowering their effort level, because the worker could think that any effort he puts in is "extra" on top off his regular wage.

If firms pay workers bonuses for effort in addition to their base wage in an attempt to give them an incentive to try harder, it may backfire because the worker may think (or realize) that his base wage is compensation simply for showing up on time every day and making minimal effort. This is probably especially true if the firm introduces the effort incentive after the worker has been working at the firm for a period of time. He's basically getting his base wage with no cost to him, and he has another "effort job" on top of that where the compensation is 100% commission based.
Looking at this from the other side of the same coin may make this phenomenon clearer. If we present a situation in which a financial penalty (as opposed to a bonus) is implemented, we might see that the same results occur. I read a study in the past regarding day-care centers: parents were told that if they showed up late to pick up their children, then they would be subject to a small fee. The result was that the number of parents who came late increased. One way that this can be explained is that parents were now exempt from the guilty feeling of being late. They were now justified in their tardiness because they were paying a price to be allowed to be late. At the same time, this fee was small enough that the cost of paying the monetary fee was smaller or equal to the parents' marginal willingness to pay, while at the same time the benefits of paying this fee(being allowed to be late) were greater than the cost of feeling guilt over being late. If the fee was significant enough where the cost of paying this fee was greater than the benefit of being freed from the guilt of tardiness, the number of parents showing up late would probably decrease.
Looking at it from the other side, we can explain it in a similar way. The act of working is usually negative; it is something that we would rather not do. But if we were sacrificing a bonus, then suddenly we would be justified in slacking off because we would be giving up this bonus as compensation. While I'm sure that this is the exact opposite of employer intentions, it is in each workers mind in which this transaction is justified. If, however, the bonus is large, the benefits from earning that bonus would outweigh the benefit of being allowed to slack off, and output would most likely go up.
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