Edward P. Lazear Stanford University1 Performance Pay: Lessons from Personnel Economics Compensation, Work Practices and Productivity Steyr July, 2003

Edward P. Lazear Stanford University2 Today’s talk All pay is performance pay Traditional incentive pay Uses - Sorting and incentives Results Relative pay Intrinsic motivation

Edward P. Lazear Stanford University3 All Pay is Performance Pay Issue of structure and formula Piece rates, commissions Hourly wages, annual salaries Which variables determine best structure? Measurability Heterogeneity Complexity

Edward P. Lazear Stanford University4 Pay Forms Pay on input or output? Input Hourly wage Annual salary Effort related bonuses Output Piece rates Sales commissions Output related bonuses Team compensation Profit sharing Stock and options

Edward P. Lazear Stanford University5 Input or Output? Measurement costs and risk aversion Output sometimes difficult to measure Complex Teams Takes time to play out (R&D) Education (earnings) Proxies – Test scores Output highly variable (risky projects) When risk or measurement is an issue, pay on input Input imperfect but often more available measure of what is desired Input is non-distorting

Edward P. Lazear Stanford University6 Discrete or Continuous?

Edward P. Lazear Stanford University7 Both Create Incentives Discrete is strong in narrow range Continuous is weak in any one range, but strong overall Not “high-powered” v. “low powered” Discrete well-suited to homogeneous workforce Both induce sorting

Edward P. Lazear Stanford University8 Choice of Pay Structure Continuous (Heterogeneous Workforce) Discrete (Homogeneous or idiosyncratic workforce) Input (Output difficult to observe) Hourly wage paid management consultant Retainer paid to a lawyer Output (Output easy to observe) Piece rate workers Non-commission salesperson

Edward P. Lazear Stanford University9 A European Issue Termination difficult Suggests use of continuous over discrete

Edward P. Lazear Stanford University10 An Example: Team Incentives European Oil Company Oil field on Arctic Ocean – great success Head office in Anchorage – total failure The lesson Production versus managers? No Peer pressure effective small groups

Edward P. Lazear Stanford University11 Results on “Performance Pay” for Managers Abowd (1990) 16,000 managers at 250 corporations Additional 10% performance  400 to 1200 basis points on stock return Leonard (1990) Companies with long-term incentive plans had significantly higher R.O.E. Kaplan (1994) Japanese executives whose compensation is tied to performance are associated with companies with higher subsequent performance Almost never find the reverse

Edward P. Lazear Stanford University12 Managerial Performance Pay The “Puzzle” If effective, why is the relation of pay to performance closer to zero than one? Jensen & Murphy, Hall and Leibman Graziano and Parigi (Italian firms have similar low elasticities) Explanations Straw man Every manager cannot own firm Groves and other mechanisms have problems Enough incentives if managers are risk averse (Haubrich) Another reason for performance pay: Information for investors

Edward P. Lazear Stanford University13 Put Your Money Where Your Mouth Is or “Skin in the Game” Venture capitalists require low base + performance pay Wage = a + b (Output) Incentive solution b=1, a<0 Sorting solution: Homogeneous managers b very small, a slightly less than alternative Always accepts positive profit project Never accepts never profit project Much evidence for this view (new, high tech firms use more)

Edward P. Lazear Stanford University14 Another Form of Performance Pay: Tournaments Almost all managers face implicit if not explicit tournaments Tournament defined as pay or non- monetary compensation function of relative performance

Edward P. Lazear Stanford University15 Tournaments Goal of tournament theory To explain salary hierarchy To explain different patterns across industries and countries Metaphor of tennis match Compensation based on relative position The larger the spread, the more effort There is an optimal spread Too much variation creates recruitment and cooperation problems

Edward P. Lazear Stanford University16 Mathematics

Edward P. Lazear Stanford University17 So… Bigger raises create greater incentives Use larger spread in “noisier” environments Higher wage differentials in new and/or risky industries Higher wage differentials in US than in Europe But bigger raises  less teamwork

Edward P. Lazear Stanford University18 Evidence on Tournaments Eriksson (1999) finds strong support of implied wage structure O’Reilly, Crystal and Main: Promotion rates Sports: Ehrenberg and Bognano and later Bronars, golf Experiments: Bull, Schotter and Weigelt (1987) and Fehr and Falk (2002), Freeman, et. al. (2003), European Science Days students

Edward P. Lazear Stanford University19 More Evidence on Tournaments Knoeber: Chickens Drago and Garvey (1998) Large raises for promotion  better attendance in 23 Australian firms Large raises associated with less sharing

Edward P. Lazear Stanford University20 Intrinsic and Extrinsic Action on the margin At some levels, makes no sense Cut commissions so will work harder?

Edward P. Lazear Stanford University21 A Traditional Human Resources View The fundamental economic theory of motivation is based on assumptions of effort aversion (people will not expend effort unless paid to do so), opportunism (people, in the pursuit of their own interests, will often misrepresent their true preferences and engage in guile and deceit), and a lack of goal alignment (employees in organizations have different agendas than the owners and, therefore, incentive systems need to be designed to force people to do what is right for the good of the organization). In the economists’ view, people are assumed to be lazy, dishonest, and at odds with the goals of the managers. Although each of these assumptions may be valid in a specific situation, or for a particular individual (for instance, when managing economists themselves), none is likely to be right in most settings with normal human beings. - Charles O’Reilly and Jeffrey Pfeffer

Edward P. Lazear Stanford University22 An Example: Lazear’s Teaching

Edward P. Lazear Stanford University23 Demand and Supply Version

Edward P. Lazear Stanford University24 Conclusion Performance pay: Not whether but what form Input or output Discrete or continuous Relative or absolute Output-based performance pay may be as important for selection as incentives Rank-order based incentives are pervasive for managers Manifestations Promotions Bonuses Status and other non-monetary factors Adverse effects on cooperation Implicit if not explicit almost everywhere so understanding essential