Incentives matter: performance pay file

Over the last two decades or so there has been a surge in the popularity of performance pay for those in executive and managerial positions within a firm. From CEOs down to middle and lower management incentive packages are now common place. One question about this approach is How does managerial performance pay affects firms' productivity and the performance of individual workers in lower tiers of the firms' hierarchy? A recent paper has tried to answer this question.

O. Bandiera, I Barankay, and I Rasul (2007) "Incentives for Managers and Inequality Among Workers: Evidence from a Firm Level Experiment", Quarterly Journal of Economics 122: 729-74, engineered an exogenous change in managerial incentives by augmenting managers' fixed wages with a performance bonus based on the average productivity of workers that they managed. One important point about this exercise was that lower-tier workers in the firm were rewarded according to the same compensation scheme throughout, so an effect were coming from the changes to the managers' pay scheme.

Bandiera, Barankay and Rasul write

In our context, as in most firms, managers can affect average workers productivity through two channels—(i) they can take actions that affect the productivity of existing workers, and (ii) they can affect the identity of the workers selected into employment. A simple theoretical framework indicates that when workers are of heterogeneous ability and managers' and workers' efforts are complements the introduction of managerial performance pay makes managers target their effort towards the most able workers. We label this a "targeting effect" of managerial incentives. In addition, the introduction of managerial performance pay makes managers select the most able workers into employment. We label this a "selection effect" of managerial incentives.

Both these targeting and selection effects will influence the mean and the dispersion of workers' productivity. Mean productivity unambiguously rises given that managers have the incentive to target the most able workers and fire the least useful. As far as dispersion is concerned Bandiera, Barankay and Rasul note that

The effect on the dispersion, however, is ambiguous. On the one hand, targeting the most able workers exacerbates the natural differences in ability and leads to an increase in dispersion. On the other hand, if only more able and, hence, more similar workers are selected into employment in the first place, the dispersion of productivity may fall, depending on the underlying distribution of ability across workers.

Bandiera, Barankay and Rasul go on to note

Our research design combined with data from personnel records on the daily productivity of individual workers allows us to provide evidence on how the provision of incentives to managers affects manager's behavior and therefore filters through to the performance of individual workers at lower tiers of the firm hierarchy. We identify the effect of managerial performance pay on average worker productivity, on the dispersion of workers' productivity, and use individual productivity data to separate the targeting and selection effects.

The design of the experiment was as follows.

We divided the peak picking season into two periods of two months each. In the first period the COO [chief operating officer] and managers were paid a fixed wage. In the second period, we added a daily performance bonus to the same level of fixed wages. The performance bonus is an increasing function of the average productivity of workers in the field on that day, conditional on average productivity being above an exogenously set threshold.

The all important results were

First, the introduction of managerial performance pay increases both the average productivity and the dispersion of productivity among lower-tier workers. The average productivity increases by 21 percent, and the coefficient of variation increases by 38 percent.

Second, the increase in the mean and dispersion of productivity is due to both targeting and selection effects. The analysis of individual productivity data reveals that the most able workers experience a significant increase in productivity while the productivity of other workers is not affected or even decreases. This suggests that the targeting effect is at play—after the introduction of performance pay, managers target their effort towards more able workers.

The individual data also provides evidence of a selection effect. More able workers, namely those who had the highest productivity when managers were paid fixed wages, are more likely to be selected into the workforce when managers are paid performance bonuses. Least able workers are employed less often, and workers at the bottom of the productivity distribution are fixed.

Third, the selection and targeting effect reinforce each other, as workers who experience the highest increase in productivity are also more likely to be selected into employment. The introduction of managerial performance pay thus exacerbates earnings inequality due to underlying differences in ability both because the most able workers experience a larger increase in productivity and because they are selected into employment more often.

Finally, we evaluate the relative importance of the targeting and selection effects through a series of thought experiments. We find that at least half of the 21 percent increase in average productivity is driven by the selection of more productive workers. In contrast, we find that the change in dispersion is nearly entirely due to managers targeting the most able workers after the introduction of performance pay. Namely, the dispersion of productivity would have increased by almost the same amount had the selection of workers remained unchanged. The reason is that the distribution of ability across workers is such that even when the least able workers are fired, the marginal worker selected to pick is still of relatively low ability. Hence, there remains considerable heterogeneity in productivity among selected workers.

So the introduction of an incentive scheme for managers effect not only the performance of the managers but also the performance and make-up of the workforce.

There is one obvious problem, and strength, of this approach. The study uses very detailed data and hence can produce detailed results. This clearly is a strength of the paper. But this data only comes from one firm, and a somewhat special situation, in particular the employment situation is rather special in that the pool of managers and workers available for employment is fixed and observable. Thus precision comes at the cost of generality.