Incentive in Organization

众所周知,现代经济体系的效率很大程度上来自于分工。而比起传统经济学家更加熟悉的市场内分工,一般人在每日的营生之中最贴切感受的或许是组织内分工。按照Coase的说法,两者拥有完全不同的工作机制。前者依靠的是价格机制(price mechanism),后者则是等级制度(hierarchy)。简单来说,同样的资源配置,前者是以人为本各取各需一拍要么即成要么两散,而后者则是主要以组织为本以命令(order)的形式进行。那么后者的命令的权限来自于哪里呢?可以想到的有来自雇佣合同上规定的权利,来自于雇主对于未来收益分配的承诺,来自于议价能力和机会成本不同所带来的风险偏好不同,以及来自对集体的服从和员工的忠诚等心理学和社会学上的因素。

价格机制和等级机制哪种更有效的?自科斯以来,这个问题被等于了问公司的边界在哪里。科斯认为等级制度中能减少一部分市场上的交易成本,包括寻找信息的成本,重复议价签订契约的成本,对未来不确定性的担忧,对信用问题的担忧等等,当然于此相对应地也会增加一部分组织内成本如管理监督成本。所以公司的边界和效率问题就成了这两部分成本的角力。Willamson在科斯的认识上着重强调了asset specificity带来的被抓软肋(hold up)问题,本质上是说由于合同无法写清未来所有的事,有一些专有的投资可能只对特定交易方有用,而不能拿到市场去随便交易,所以产生了一个对风险的担忧,只能在组织内解决(当然这个想法是有问题的,后来Willamson承认了这个风险也可以在组织间解决)。但是Willamson包括后来Hart的研究都把方向和着重点放到了资产和中间生产交易上,认为公司是资产的合集。更大的问题是,Willamson认为公司内命令机制所导致的激励效果一定是比市场低的,Hart也认为转移剩余所有权后会带来激励问题,而我们应该把剩余所有权给那些激励效用最大的主体。从直觉上来讲,这样似乎是没错的,给人打工自然没有自己创业来干的勤奋。

然而另外有一些经济学家(Alchian&Demsetz, Milgrom&Roberts, Nakabayshi&Ishiguro, etc.)认为公司的存在并不只是为了降低交易成本,与Williamson的意见相反,他们认为公司也可以成为一种激励的手段,或者说哪怕在一个交易成本为0的世界,公司仍能作为激励(和信息提供)机制而存在。从Arrow提出逆向选择(adverse selection)和道德风险(moral harzard)以来,经济学家早就开始认识到市场上也好,组织内也好,合约都不是万能的,正相反,合约的约束经常是千疮百孔的。不完全合约,私人信息(private information),利益不一致,风险厌恶,这几个因素会产生道德风险,逃避(shirking),搭便车,机会主义等一系列问题。面对这许多的问题,正是公司这样的组织才能选择比市场更有效的激励方式来促进人们工作。比如组织的命令安排和监管会减少逃避和机会主义,促进合作和分工。更重要的是哪怕是和市场可以采取的激励手段同样,组织内作为一个整体把市场上的激励机会带进组织内,降低个人的信息搜寻成本(其实本质上有些接近Knight的观点)。然而,Willamson和Hart的问题依然存在,组织内依然存在利益不一致和私人信息带来的激励不充分,道德风险,机会主义,搭便车,逃避问题,一个都没少。所以现在关键变成了,什么才是好的有效的组织内激励体制?

再次强调一下,一切问题的根源(似乎)是,利益不一致和私人信息。也就是说理论上所有激励手段应该尽量使得组织内享有共同的利益,并且所有的逃避搭便车等行为都被及时并且最好低成本地发现和惩罚。合约理论(Contract theory)的教科书就是第一个方法来解决道德风险的问题的。我们设计合约让对方可以从自己的努力中获得好处,如果对方风险厌恶,我们就多给好处,如果对方难以惩罚,我们也多给好处,反正就是我们把一部分公司的利润给出去和你的业绩挂钩,总能让你拼命努力。当然这种方法也有很多限制,成果可能随机性很高,也就是说努力程度可能很难从成果里得到。team单位工作的成本可能个别人通过寻租占去。或者有些人努力的负效用很大,而且确切值并没有办法观察到。公司的组织构架越复杂,业务结构越复杂,以上问题就可能越突出,想要实施完美激励就越难。

而且经济学和管理学的一些研究发现,激励的难度或许还不止于此。

Self-Control and Demand for Preventive Health: Evidence from Hypertension in India Liang Bai, Benjamin Handel, Edward Miguel, Gautam Rao, NBER Working Paper, August 2017

Problems:
Self-control problems → constitute a potential explanation → for under-investment in preventive health care (in low-income countries)
← A commonly proposed policy tool: offering consumers commitment devices

Methology:
a field experiment in rural India + a theoretical model  → clear reduced-form facts + structural estimates of the key utility and belief parameters
(approach remains relatively rare in the development economics literature, building on a recent stream of work in structural behavioral economics (DellaVigna et al. 2012; Augenblick et al. 2015
→ advantage: identification of structural parameters relies on exogeneous variation due to randomization → allows to conduct welfare and counterfactual analysis, which ultimately may be tested through additional experimentation)
→ estimates of the distributions of sophistication about present bias (only sufficiently-naive agents are predicted to engage in procrastination; conversely, only sufficiently-sophisticated agents will demand commitment and use it to achieve the first-best.
=>Understanding the distribution of sophistication is thus crucial to understanding the nature of self-control challenges, and to identify the appropriate policy responses. )

Study:
=> evaluate whether [ commitment contracts + price discounts ] → increase preventive health visits by hypertensive patients
→ results are generally disappointing: takeup of the contracts was modest and varying in different types + few of those who purchased the contracts ended up utilizing health services (losing money without experiencing any health benefit) + objective health outcomes (blood pressure, weight) do not change in the treatment groups

develop and structurally estimate a pre-specified model of consumer behavior under present bias with varying levels of naivete
=> a large share of individuals being partially naive →
a] agents are likely to demand costly commitment → but then systematically accept commitments which are not strong enough to succeed; 

→ if restrict the set of available commitments to strong commitments → poses a tradeoff with consumers’ demand for flexibility in an uncertain world
b] many agents who do not demand a particular commitment device might simply be over-optimistic about their self-control problems (they are sophisticated enough to demand some commitment, but overly optimistic about whether a given commitment is sufficiently strong to be effective)
→  even offering strong commitments may leave unhelped a number of consumers with self-control problems.
=>>> (under plausible model assumptions) offering individuals commitment contracts reduces social welfare

 

Double for Nothing? Experimental Evidence on the Impact of an Unconditional Teacher Salary Increase on Student Performance in Indonesia Joppe de Ree, Karthik Muralidharan, Menno Pradhan, Halsey Rogers NBER Working Paper, December 2015

Question:
How does a large unconditional increase in salary affect employee performance in the public sector?

first experimental evidence:
a unique policy change in Indonesia that led to a permanent doubling of base teacher salaries
→ using a large-scale randomized experiment across a representative sample of Indonesian schools that accelerated this doubling of pay for teachers

=> [+] we find that the doubling of pay significantly improved → teacher satisfaction with their income + reduced the incidence of teachers holding outside jobs + reduced self-reported financial stress
=>> [-] Nevertheless, after 2&3 years, the doubling in pay → led to no improvements in measures of teacher effort + no impact whatsoever on student learning outcomes
=>>> contrary to the predictions of various efficiency wage models of employee behavior (including gift-exchange, reciprocity, and reduced shirking) + those of a model where effort on pro-social tasks is a normal good with a positive income elasticity → large unconditional increases in salaries of incumbent teachers had no meaningful positive impact on student learning

 

Why Incentive Plans Cannot Work by Alfie Kohn in 1993

a growing collection of evidence do not support the belief in behaviorist theory that people will do a better job if they have been promised some sort of incentive. Rewards even undermine the very processes they are intended to enhance. ← this failure of  incentive program is due to the inadequacy of the psychological assumptions that ground all such plans.

Research suggests that, by and large, rewards succeed at only temporary compliance → When it comes to producing lasting change in attitudes and behavior → rewards, like punishment, are strikingly ineffective + once the rewards run out, people revert to their old behaviors.
e.g. Studies show that offering incentives for losing weight, quitting smoking, using seat belts, or (in the case of children) acting generously is not only less effective than other strategies but often proves worse than doing nothing at all => Incentives, seen as extrinsic motivators, do not create enduring commitment to any value, attitude or behavior

productivity studies: have conclusively shown: people completing a task or doing task for rewards simply do not perform as well as those who expect no reward at all
← the more cognitive sophistication and open-ended thinking that was required, the worse people performed when working for a reward

most organizational studies: have tended to focus on the effects of variations in incentive conditions, and not on whether performance-based pay per se raises performance levels

a number of studies: examined whether or not pay, especially at the executive level, is related to corporate profitability and other measures of organizational performance → often slight or even negative correlations between pay and performance ← typically interpreted as evidence of links between compensation and something other than how well people do their jobs => maybe just the causal arrow are wrong
+ financial incentives were virtually unrelated to the number of workers who were absent or who quit their jobs over a period of time
+ by contrast, training and goal-setting programs had a far greater impact on productivity than did pay-for-performance plans

Why Rewards Fail
Why do most executives continue to rely on incentive programs?
→ Rewards buy temporary compliance, so it looks like the problems are solved → It’s harder to spot the harm they cause over the long term

The fundamental flaws of behaviorism →  psychological theory

1. “Pay is not a motivator.”
studies have found that when people are asked to guess what matters to their coworkers or subordinates → they assume money heads the list
when “What do you care about?” → only fifth or sixth

→ even if people were principally concerned with their salaries → does not prove that money is motivating to do better work or even, in the long run, more work
→ too little money demotivate and undermine performance → does not mean that more money necessarily follow increased motivation and better work

2. Rewards punish
coercion and fear may produce movement but destroy motivation and create defiance, defensiveness, and rage
→  rewards have a punitive effect → reward itself may be highly desired, but by making that bonus contingent on certain behaviors, managers manipulate their subordinates → experience of being controlled is likely to assume a punitive quality over time → not an environment conducive to exploration, learning, and progress
→ not receiving a reward one had expected to receive = punished

3. Rewards rupture relationships.
incentive programs, and the performance appraisal systems that accompany
→ damage relationships among employees →  reduce the possibilities for cooperation → pressuring  for individual gain not improving the system for collective gain
→ also damage relationships between supervisors and subordinates → employees may be tempted to conceal problems and present themselves as infinitely competent

4. Rewards ignore reasons.
relying on incentives to boost productivity → does nothing to address possible underlying problems and bring about meaningful change ← less effort on treating workers well, providing useful feedback, social support, and the room for self-determination
→ pay for performance actually “impedes the ability of managers to manage”

5. Rewards discourage risk-taking.
whose income depend on their productivity or performance rating → become less inclined to take risks or explore possibilities, to play hunches or to consider incidental stimuli → rewards hurt creativity
→ tended to choose easier tasks as the payment for success increased
→ tend to lower sights when they are encouraged to think about what they are going to get for their efforts

6. Rewards undermine interest.
→ rewards, like punishment, may actually undermine the intrinsic motivation that results in optimal performance → receiving a reward for a particular behavior → feel that our work is not self-directed. Rather, it is the reward that drives our behavior / “If they have to bribe me to do it, it must be something I wouldn’t want to do.”

Dangerous Assumptions
Some managers insist that the only problem with incentive programs is that they don’t reward the right things. → psychological factors involved → e.g. intrinsic and extrinsic motivation are conflict
→ the use of rewards is not a response to the extrinsic orientation → rather, incentives help create this focus on financial considerations → people are thus likely to become less interested in their work, requiring extrinsic incentives before expending effort → self-fulfilling prophecy

 

 

When Picking the Wrong Person for the Job Is the Right Move

Question:
When there’s an important job/big contract/reallocated capital to fill → obvious the best person/supplier/division for the role?

according to new research by Daniel Barron&Michael Powell → sometimes it might be in a firm’s interest to promote the wrong person, or sign a contract with the wrong supplier ← because that party has performed very well previously → to fulfill an earlier promise that excellent work would be rewarded in the future => establish credibility with its employees

← picking the wrong candidate or supplier comes at an obvious cost => trade-offs

The Importance of Credibility:
e.g. design the contract with your supplier for developing and producing impressive or innovative system → subcontract design rather than a explicit task →  inducing best effort ← best effort is, frequently, very tough to motivate with a formal contract similarly hard to draw up a formal employment contract that specifies the care, effort, and ingenuity 

→ promises (implicitly or even explicitly) → induce effort now  ← promises are informal = no enforcement  => promises are only effective motivators if viewed as credible

Plenty of Trade-offs
To explore the importance of credible promises to a firm
→ use game theory to model the firm’s contracts with its employees and suppliers

contracts [ formal terms + promise(performance beyond → rewarded) ] → multiple contracts up for grabs over time → each party had the chance to reward or punish the other based on its previous actions
(in model, rewards and punishments were monetary → in practice, might take the form of good or bad terms in future contracts)

credibility ability to motivate excellent performance ← comes from rewarding past successes (regardless of best choice for new work moving forward → e.g. not be promote even if effort ← someone else who would be a better fit → no effort)

reality not always keep every informal promise ← sometimes the costs of assigning work to the wrong party are just too high + there are rarely enough rewards (capital/position) to go around
=> need to balance out [ who really needs the credibility + Which relationship needs the credibility at each moment in time ] ← model was designed to identify

Key tradeoff [ benefit of motivating someone + cost of demotivating someone else + cost of passing over the best person for the task (+ building credibility) ]
=> model → rewarding past excellence is most beneficial when
→ an employee or supplier has truly excelled previously + competing parties have not
→  costs of favoring the excellent are relatively low

Takeaways for Firms
=> some situations → the benefits of rewarding past performance are so strong → overcome the benefits of actually giving the job to the right person => promote the wrong guy
=> when do the best thing going forward → understand what implicit promises breaking → losing credibility → affect people’s incentives going forward

e.g. Historic evidence from the auto industry hints at the importance of keeping these promises in mind

In the late 1980s and early 1990s, U.S. manufacturers generally held open auctions, where suppliers bid on each contract without the expectation that strong performance on one contract would give them an edge in future bids.
Japanese manufacturers, were able to motivate their suppliers to go above and beyond the terms of their contracts by restricting themselves to a fairly small set of long-term suppliers ← history dependent → over time, a supplier could break into this closed supply chain if they performed well
→ Ultimately, this arrangement allowed the Japanese manufacturers to procure better work from their suppliers + at lower costs

“Doing something that looks like it might not be efficient today may actually help to cultivate long-term relationships—started in the past—going forward, and therefore actually be more efficient.”

当然哪怕单纯的激励也有不少的成功案例的研究。

Team Incentives and Performance: Evidence from a Retail Chain

a struggling bakery chain in Germany:
→ a large company with a century-long heritage
→ recentlysales drop amid pressure from supermarket chains
→ couldn’t compete on price → decided to differentiate by focusing on high-end baked goods → still needed to motivate its relatively low-paid shop employees to increase sales

← A bonus program was rolled out to half of the 193 bakery shops in the company’s fleet
← locations that reached their sales target for the month got a bonus of 100 Euros, divvied up among the employees according to their hours worked
← bonus increased by 50 Euros for each percentage point above the target that they hit + capped at 300 Euros

Questions:
1] “Bonuses are used widely to motivate corporate executives, they are less commonly used for rank-and-file employees.”
2] “Nowadays people are quite skeptical about bonus systems” “When we suggested this with the company, the reaction was we have never thought of this before,”
3] corporate managers worry that a) “free-riding” in team work: lazy team members could ride on the coattails of more industrious ones, sharing in the gains equally; b) paying bonuses would cancel out any profitable sales gains.
4] “I think what we can show here is that bonus systems work, but it all depends on how they are designed.”
5] in 2015, paper “The Ongoing Evolution of US Retail: A Format Tug-of-War” shows that productivity gains among retail workers did not benefit workers.

Results:
1] effectively motivate team members to achieve common goals →
+ Sales in shops with the bonus program increased by around 3%
+ Employee wages increased by 2.2 % on average, and up to 12% for some people
+ it didn’t cancel out company profits, for every dollar paid out in bonuses, the company generated an exta $3.80 in sales and $2.10 in operational profit.
→ strategy can be lucrative for both the company and its employees

2] worked through bot boosting sales
not by “upselling” more expensive products to customers
→ but through more efficient teamwork, achieving sales gains by moving customers through the checkout lines faster and drawing more people into the stores

3] It did not work in smaller cities where efficiency did not matter given not enough traffic in town.

The China Shock: Why Germany is different Dalia Marin 2017
Europe’s exports superstar: It’s the organisation! D Marin, J Schymik, J Tscheke – 2015

→ explore the organisational responses to competition of 14,000 exporting firms in 7 European countries
→ examine the export business model of the median exporter and of the top one percent exporters in each country

Findings on the features of uperstars:
1] Germany is the leading quality exporter in Europe
→ German firms introduced a decentralised management style → delegating decision power to lower levels of the firm hierarchy → more autonomy in decision making + workers at lower levels of the firm hierarchy are better informed about market demands → provides incentives for workers to improve product quality → helps firms to compete in quality rather than price
2] Exporters which abstain from any organisational adjustment do very badly
3] Offshoring production to low-wage countries reduces costs allowing exporters to compete on price ← Germany’s exports are less vulnerable to price increases, while France and Italy respond strongly to price changes → costs reductions via offshoring benefits these countries most.

→ The focus on product quality has a high appeal to the rising Chinese middle class purchasing German cars as well as to Chinese firms importing machine tools from Germany. 

 

Update 2017/09/23

Team Incentives, Task Assignment, and Performance: A Field Experiment

The performance of a work team commonly → depends on the a) effort exerted by the team members + b) on the division of tasks among them
← However, when leaders assign tasks to team members, performance is usually not the only consideration →  Favouritism + employees seniority + employee preferences over tasks + fairness considerations

=> Team incentives have the potential to curtail the role of these factors in favor of performance ← in particular when the incentive plan includes both the leader and the team members

=>> results of a field experiment designed to study the effects of such team incentives on task assignment and performance → introduce team incentives in a random subsets of 108 stores of a Dutch retail chain → no effect of the incentive, neither on task assignment nor on performance

 

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Update 2017/9/27

金銭的・非金銭的報酬とワークモチベーション 安藤至大

Pay enough or don’t pay at all U Gneezy, A Rustichini – The Quarterly Journal of Economics, 2000

Economists usually assume that monetary incentives improve performance ← psychologists claim that the opposite may happen
→ 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

 

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Take 5: How to Motivate Employees

Companies want employees who are motivated to work hard and work ethically. Many of us assume the best way to incentivize that is by offering a promotion or a big bonus for a job well done.

But is that really the case? Are there sometimes better ways to motivate employees?

Several Kellogg School faculty members have researched which employee incentives work best. And, it turns out, our instincts about cold hard cash are not always right.

1. Sometimes Financial Incentives Are the Best Option

Promotions are the ultimate motivator. But not all companies have the ability to dole out promotions as incentives. What can you do to keep employees motivated if your organization’s structure is relatively flat, with few promotions to go around?

Michael Powell, an associate professor of strategy, Jin Li, an assistant professor of strategy, and a coauthor created a mathematical model to investigate. They discovered that companies that can’t offer promotions can still motivate employees by paying them more.

Another idea for startups and other fast-growing firms is the promise of new opportunities down the road as new teams or departments get added.

“Firms that are expanding are going to find it easier to use career-based incentives,” Powell says. “When the firm’s growth starts to level off, you have to adjust expectations, because you have significantly less flexibility.”

For companies that are not growing quickly, you might want to give stock options or award bonuses.

2. How Employee Incentives Can Backfire

So employees like being rewarded with money. But dangling a bonus as an incentive comes with risks for employers.

Imagine a CEO who wants to meet the earnings target that triggers a big bonus, so he opts to cut maintenance expenses to a potentially dangerous level. Or a company that offers salespeople monthly bonuses for hitting a certain quota. On the last day of the month, the sales team is likely to offer steep discounts to customers to get over the line.

So how do you structure monetary rewards to encourage hard work while discouraging reckless risk-taking or gaming of the system? Three members of Kellogg’s strategy department, assistant professors Daniel Barron and George Georgiadis, and professor Jeroen Swinkels, investigated this question.

They found a downside to rewards that are triggered at a specific threshold—say, 1,000 cars sold a month—while nothing happens just below that threshold, when 999 cars are sold. Namely, this type of contract does not necessarily align an employee’s incentives with that of the company.

The best option for assuring alignment is a simple or “linear” contract, where reward is directly proportional to performance. There is no threshold to game: a CEO is compensated equivalently for the same rise in profits regardless of whether the firm barely hits or barely misses its target.

3. Risk Aversion Can Motivate Executives

Companies do want to encourage smart risk.

Yet research from associate finance professor David Matsa suggests that may not happen when managers are compensated with stock grants. Stock ownership can incentivize executives to play it safe in hopes of protecting the value of their stock portfolio and preserving the sheen of success that will land them their next job.

In another study, Matsa and his coauthor investigated the behavior of over 2,200 companies, each of which learned that a chemical used in its production process had been declared a carcinogen.

In the face of uncertainty and potentially crippling liabilities, what did the companies do?

“They started buying other firms,” Matsa says.

Discovering that their workers had been exposed to a carcinogen was linked to a 6% increase in acquisitions. But critically, these acquisitions didn’t create value for shareholders. That’s because, rather than making strategic purchases, the troubled firms overpaid for large and unrelated “cash cows”—firms whose healthy profits might help the firm avoid financial distress from any future payouts the company would have to make.

“We likened it to how tobacco firms diversified into food when the health risks of smoking became more pronounced legally,” says Matsa. “The managers were looking for a way to reduce risk, which both protects their career and their stock holdings.”

Instead of using equity as an incentive, Matsa suggests using stock optionswhen you want to motivate executives to take smart risks.

4. Do Performance Incentives Make Us Greedy?

Most research on incentives looks at how well they motivate employees. But how do incentives change how people think about the incentive itself?

In other words, does an employee in a commission-based job feel differently about money than a worker with a fixed salary?

The answer appears to be yes, according to research from Loran Nordgren, an associate professor of management and organizations.

He and a coauthor found that people who are rewarded based on their performance express more desire for money than people who receive fixed payments—even when the amounts they ultimately earn are similar.

In one experiment, the researchers had participants find grammar mistakes in texts. One group of participants was compensated via an incentive of 10 cents per error corrected, up to $1; the other group got a flat payment of $1. Afterward, all participants rated how much they thought about money during the task.

Participants in the performance-incentive group rated the frequency of money-related thoughts at 4.38 out of 7, compared with only 2.87 in a second group.

Nordgren suggests that companies might want to consider the consequences of increasing workers’ materialism, such as tougher negotiations with employees who want higher salaries or eventually losing workers to better-paying jobs.

5. Employee Incentives at Nonprofits

There’s another reason why employers might want to avoid touting a job’s financial incentives: for nonprofits, high salaries can turn away applicants committed to the organization’s social mission.

“Increasing financial incentives, especially in the social sector, could backfire,” says Erika Deserranno, an assistant professor of managerial economics and decision sciences.

She worked with an Ugandan nonprofit that was hiring health workers. The group allowed Deserranno to tweak how the positions were advertised, creating three different job ads that described the level of compensation as either low, medium, or high. Applicants who were offered jobs were tracked for two years.

When the job was advertised as high paying, Deserranno found that potential applicants were 18% more likely to believe that the primary purpose of the job was to earn money rather than serve the community. Furthermore, she found that applicants with a personal interest in earning money were 40 to 50 percent more likely to apply for the job when it was described as medium- to high-paying, compared with when it was advertised as low paying.

On the flip side, increasing financial incentives turned away potential applicants who were focused on helping the community. People with prior experience as a health volunteer, or who described themselves as valuing the job’s community impact over its earning potential, were 20 percent less likely to apply when the job was advertised as being highly paid.

 

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Finding the Right Performance Incentives to Motivate Employees

Based on the research of Daniel BarronGeorge Georgiadis and Jeroen Swinkels

Say you are an executive of a company desperate to meet market expectations. If you meet them, your stock options hit their strike price—but it looks like the firm’s performance is going to come up short. You could make a last-ditch effort to enter a new market, but it’s risky. Under other circumstances, you would never consider it. Do you go for it anyway?

Or consider that you are a portfolio manager who receives generous bonuses for strong performance, but pays nothing out of pocket for generating losses. Do you opt to sell mortgage-backed securities or credit default swaps, which have an extremely high probability of turning out favorably—but a small probability of blowing up the firm?

In both of these cases, you just might. After all, if the gamble fails, you are not much worse off. Your stock options are still worthless; your bank account balance is preserved. And if the gamble succeeds, terrific!

As a way to motivate everyone from salespeople to CEOs, organizations often disproportionately reward performance above a specified threshold.

For employees, “the idea is that increasing output a little bit gives me a lot relative to losing output,” says Dan Barron, an assistant professor of strategy at the Kellogg School.

But a recent study by three Kellogg School researchers—Barron, George Georgiadis, an assistant professor of strategy, and Jeroen Swinkels, a professor of strategy—suggests that simple contracts that reward performance proportionately, thus doing away with a magical threshold, may offer a better way of aligning employees’ incentives with those of the company.

And the benefits could reach beyond firms.

“Those types of incentive structures were a key driver of excessive risk-taking, which led to the financial crisis,” says Georgiadis. “So thinking about the incentive contracts that deter this kind of risk-taking behavior is important.”

Motivated to Game

The reasoning behind incentive schemes with a “threshold” feature makes intuitive sense: What company wouldn’t want to use the lure of a huge payoff to eek out extra effort from employees?

But there is a potential problem: gaming. Employees who game a contract are, in a sense, allowed to reap rewards while putting forth less effort than the contract intended.

“They don’t have to work as hard to make their quotas. If they happen to fall short, you just take on a little bit of risk,” says Barron. “Why would I want to exert all the hard work that it takes to actually shift output up when I can instead just take a little gamble and I’ll probably end up okay anyway?”

So what kind of incentive scheme cannot be gamed, but still motivates employees to work hard?

To find out, the researchers built a mathematical model to explore how employees might behave under various contracts. (The research falls under “contract theory,” the same discipline for which the most recent Nobel Prize in economics was awarded.)

“How can the firm ensure that, when the time comes for an employee to make the decision about how to behave, his incentives are aligned with the firm’s?” asks Georgiadis.

They found that a simple or “linear” contract is generally best. This means that the reward offered is directly proportional to how an employee performs and the risks that she takes. There is no threshold to game: a CEO is compensated equivalently for the same rise in profits regardless of whether the firm barely hits or barely misses its target.

The researchers also looked at a third type of contract, where performance below a threshold is disproportionately punished. They found that while it does not encourage gaming, it also does not adequately reward strong performers. If an employee only has to perform adequately to receive a reward, why would he bother working harder, or taking even a smart risk?

“Linear contracts are optimal. They provide the strongest powered incentives that do not induce gaming,” says Barron.

Importantly, linear contracts neither encourage nor discourage actual risk-taking—an “inevitable part of any profit-making venture,” says Barron. “What we want you as an employee to do is take on smart risks.”

In other words, risks that are not driven by gaming.

Other Applications

Linear contracts can ward against a second kind of gaming as well—one that, the researchers found, is mathematically equivalent to risk-taking: shifting output across time.

Say, for instance, you are a salesperson looking to meet your quota for July. It is the last day of the month, and you are just one sale short of a huge bonus. How steep of a discount are you willing to offer the next customer through the door—if she signs the paperwork today?

“It’s ultimately the same kind of gaming,” says Barron. Why should a salesperson put in the effort to sell more cars all month long when a steep discount on July 31st can result in the same reward? A linear contract, which stipulates the same commission regardless of when a car is sold, would eliminate this incentive.

The researchers note that sometimes these two types of gaming can work in tandem.

“What CEOs sometimes do,” says Georgiadis, “is they see they’re going to miss their earnings targets, and then they cut maintenance, or R&D projects, or some investments on this or that, or training expenses. By doing this, they meet the targets—but they’re really shifting output earnings across time, because they’ll have to do that maintenance at some point. And at the same time, they’re shifting risk, in the sense that if I cut maintenance, that means there is a higher chance of a disaster happening.”

Contracts that incentivize gaming can affect more than individual organizations; they can affect the broader economy. For instance, plenty of experts have linked the financial crisis in 2008 to “perverse incentives for bankers and portfolio managers,” says Georgiadis. “[Their firms] were giving them very strong incentives if they made money, and if they lost money, they didn’t have to pay anything out of pocket.”

“On top of that,” says Georgiadis, “they would get a bonus if their performance was above a threshold. That kind of incentive scheme is exactly what induces ‘selling insurance’—basically taking huge left-tail risks, which is what we saw happened with those credit default swaps and mortgage-backed securities.”

“The same kind of contracts that are going to deter the bad kind of risk-taking from the firm’s perspective also potentially can be used to deter the bad kind of risk-taking from society’s perspective,” says Barron.

Advice for Organizations

How can companies know whether their incentive schemes are likely to be gamed by employees? There are no hard and fast rules, say the researchers.

“It’s difficult to infer from outcomes that this gaming is going on,” says Barron. He advises companies to “look at the incentives that are offered, and put your feet into [the shoes of] your very evil brother. How would you game those incentives?”

As a firm, says Georgiadis, “if you are worried about gaming, then a linear contract is generally a good idea. It’s not always a good idea, and there are caveats: our model is not the world. But a linear contract is a good idea.”

“What I would like people to take away more than anything else is an awareness of the kinds of gaming that people can do and the kinds of incentive schemes that encourage that gaming,” says Barron. If, at the end of the day, companies understand that a bonus scheme is going to encourage gaming—and they offer it anyway—then fine. “But don’t do it and then later realize, ‘oops, we introduced a lot of gaming that we weren’t expecting.’ At least walk into that trap with your eyes open.”

 

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How to Keep Employees Motivated in the Absence of Promotions

Based on the research of Rongzhu Ke, Jin Li and Michael PowellSure, the satisfaction of doing a good job can sometimes be enough to push employees to work hard. But often it is the lure of that next good job—a promotion, and the raise and bigger office that come with it—that drives staff to excelThe opportunity for advancement, as any employee or manager knows, is a great way to motivate employees. Firms do not simply hand out promotions to any employees doing good, or even outstanding, work, however: they are constrained by their organizational structure, the makeup of their existing employees, and company policies limiting the number or timing of promotions.“A firm’s organizational chart is going to impact workers’ career paths through the personnel policies it enables the firm to put in place,” says Jin Li, an assistant professor of strategy at the Kellogg School. And while the chance of promotion is a boon for employees and an incentive to keep them loyal to an employer, he says, a lack of opportunity will drive talented workers elsewhere.

How can companies keep employees motivated even when there are not plentiful promotions to hand out? Li teamed up with Michael Powell, also an assistant professor of strategy at the Kellogg School, and Rongzhu Ke, at the Chinese University of Hong Kong, and built a mathematical model to investigate how companies can best use promotion policies, given their organizational constraints.

The model was based on previous research that emphasized that workers may be motivated by the fear of losing high-paying jobs. But the researchers observed that firms’ personnel policies are richer than their wage policies alone. So, they asked, how can firms work around their promotion constraints by manipulating salaries or other perks, like stock options, to keep workers motivated if opportunities for promotions are scarce?

Opportunities Worth Working For

Promotion really is the most effective way to motivate workers, their model confirmed. When employees are striving to move up the career ladder, Li says, “the firm can get the workers to do well while paying the lowest amount of money.”

Their model shows that it can be cheaper to motivate workers with career advancement rather than with cash. This is surprising, because one of the main reasons why workers value promotions is that they come with a pay bump. A key insight of Li, Powell, and Ke’s model is that the higher pay in higher positions serves two purposes: it motivates the higher-level employee to work hard to keep that job, and it motivates lower-level workers to work hard to eventually get that job.

But promotions do not happen in the same way, or with the same frequency, at every company. Firm-level differences, like its size and organization, can impact individual workers’ careers, Powell says. “A worker will have a different career experience at a different employer, even though at the beginning of her career, she might not care which firm she works for,” he says.

The size of a company, the model suggested, matters quite a bit—especially because larger companies tend to have what Li and Powell call larger spans, meaning more employees at one rung of the ladder for each employee at the rung above. Take law firms as an example: small firms generally have fewer associates under each partner than larger firms.

That means that in smaller companies, with smaller spans, each associate has a fairly good shot at making partner—or, in non–law firm terms, each entry employee has a sizable chance to become a manager. Because of that, wages can stay relatively low: associates can reasonably assume they will become partners, and get the benefits that come with that, later in their careers.

In larger firms, however, with more entry-level employees per manager, it is more difficult to get one of the few top spots. What can companies do, then, to keep workers motivated? Put simply: pay them more.

For one thing, the salaries of the entry-level employees will be higher. “When the job offer itself is already pretty good,” Li explains, “the promotion is less important.” And the salary for the managers goes up, too. Since workers are not as likely to get promoted, the firm has to dangle a more appealing carrot—in this case, a much larger salary—to keep them working hard and hoping to move up.

Another way to make sure that the opportunity for advancement keeps motivating workers is for big companies to force turnover higher up the ladder. Investment banks, for instance, often buy out a portion of their partners each year—even if those partners are still doing productive and profitable work—to make room for younger employees to advance. The fact that top jobs will open up more frequently helps motivate more junior workers—but it has a downside too. Knowing that the top job has a limited tenure can make it less valuable (and less enticing) to younger workers, so firms have to compensate for that, too, with higher wages after a promotion.

Keeping Employees Motivated with a Clear Path

Promotions are the most motivating when the next step upward is never too far out of reach. How can flat organizations—with very few opportunities for promotions between a team’s entry-level and top jobs—keep employees engaged and working hard?

Li and Powell’s model has a few implications for such companies. The first is that growth can provide new opportunities—think of early employees at a start-up, who start out in junior roles and are soon running their own teams. “Firms that are expanding are going to find it easier to use career-based incentives,” Powell says. “When the firm’s growth starts to level off, you have to adjust expectations, because you have significantly less flexibility.”

Firms that are not growing may have to compensate for the lack of advancement opportunities in other ways. “In order to motivate workers, you might want to give stock options or award bonuses more,” Li says. Checks and balances within a flat organization, and long-term incentives like stock options, can help ensure that employees are making choices to benefit the company in the long run—and not simply creating a short-term improvement to earn a bonus.

It is also important for every company to remember that promotions do not happen in isolation: they are tied in with a firm’s policies, salaries, and org chart. Additionally, it is important to keep opportunities for individual workers in mind when making offers and structuring teams.

“If you’re going to promise people that if they work for you for three years, they’re going to get promoted, you need to make sure that you need people at higher-level positions three years from now,” Powell says. “When you’re managing your workforce, you need to manage the careers of the workers themselves.”

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