Why are non-linear incentives so prevalent? Experimental evidence on sorting and overconfidence

Non-linear incentive schemes are commonly used in corporate environments, yet there is little research explaining why employees and firms prefer such schemes. We study worker sorting choices and performance under linear and convex piece rates in a laboratory multiplication task. We find persistent and robust overand underconfidence over repeated tasks despite clear feedback on performance. Furthermore, overconfident subjects are much more likely to choose the convex piece rate, even when it leads to lower pay, and despite feedback that they are making a mistake. Additionally, while random assignment of incentive scheme choice yields no performance difference, when given a choice subjects picking the linear scheme perform significantly worse on the task. Subjects with the worst performance when choosing the linear scheme were also more likely to be underconfident. These results suggest that offering convex incentive schemes could provide significant benefits to firms by “sorting in” overconfident workers and “sorting away” workers likely to be unmotivated. * We thank Matthew Chao for excellent research assistance, and participants at the ESA 2009 conference and seminars at the University of Michigan, Columbia University, the University of Sydney, the University of Melbourne and Harvard Business School for helpful feedback. [2] Introduction The use of non-linear, performance-based incentive contracts is very common in many business environments. The most well-known example is salesperson compensation, where surveys indicate nearly 90% of salespeople are compensated via a non-linear system (Heide 1997). In addition, entrepreneurs typically enter into highly non-linear, performance based contracts when signing contracts with venture capitalists (Wasserman, 2006). Many other types of performance-based pay, including stock options, bonus systems based on defined metrics, and pay based on subjective performance, often exhibit non-linear characteristics. There has been little research on why firms and employees so commonly agree to non-linear incentive contracts, and many scholars of incentives are puzzled by such agreements. From the firm’s perspective, non-linear incentives are highly distortionary, as employees manipulate their work in order to maximize their pay. Roy (1952) provides the seminal discussion of this behavior with a detailed study of gaming behavior by machine shop employees in response to a highly non-linear piece rate system, which resulted in employee shirking an estimated 50% of the time. Larkin (2007) estimates that “timing gaming” by salespeople costs a leading enterprise software vendor 4-7% of revenue as salespeople cut price in response to non-linear incentives. Additionally, non-linear incentives in the forms of bonuses have been shown to lead to fraudulent behavior (Schweitzer et al, 2004). Furthermore, there has been little research on why employees may find non-linear incentive contracts to be desirable. A basic tenet of agency theory from economics holds that employees are risk averse around pay (Jensen and Meckling, 1976), yet non-linear incentives often introduce substantial risk since performance is not rewarded with pay unless some hurdle point is reached. That so many employees agree to these types of contracts is puzzling in light of this prediction from agency theory, 1 Non-linear commission schemes in sales environments take many forms. The most typical is a quota system, where salespeople receive no commission on sales until their “quota” is filled, after which they receive a commission on incremental sales. Bonus pay for reaching a discrete sales target is another common example. [3] which is the dominant lens by which management scholars have analyzed compensation (Gino et al, 2009). These results have led some scholars to opine that companies should desist from using non-linear incentives. Michael Jensen, for example, argues that “all kinks, discontinuities and non-linearities [should be taken] out of the pay-for-performance profile of each employee and manager” due to the “huge costs [they] impose on organizations” (Jensen, 2004). Other scholars feel that the widespread use of nonlinear incentive schemes suggests “there must be some benefit of these contracts that outweighs these apparent costs” (Lazear and Oyer, 2009). Despite these opinions, little research has been done that actually investigates the possible benefits of non-linear schemes to firms or employees. In this paper, we explore the role that the behavioral bias of overconfidence may play in explaining the prevalence of non-linear incentive schemes. In particular, we study convex or “kinked” incentive schemes commonly seen in sales environments. In these schemes, a salesperson’s commission on a successful sale rises the more revenue her sales generate within a financial period. For example, Larkin (2007) reports that at the software vendor investigated in the paper, the commission on a sale could range from 2% to 25%, depending on the total sales the salesperson had made in that quarter. Larkin reports that these “kinked” systems are common not only in enterprise software, but also in hardware, telecom equipment, aerospace and other industries. Overconfidence potentially interacts with convex incentive schemes in several ways. First and foremost, a convex scheme is arguably more attractive to potential employees who are overconfident, in that they overestimate the likelihood of receiving a commission rate from the steep portions of the curve. If confidence is an important skill for employees to have – a common argument in the sales force management literature (Zoltners et al, 2006) – then a convex incentive scheme could help attract and retain these desirable employees. Secondly, firms may reduce their wage bill by proposing convex 2 The industry term for these pay schemes is an “accelerating” commission system, because the commission increase at each “kink” in the commission curve is communicated -as an “accelerator” from the base commission rate. [4] schemes to biased employees, particularly if these employees fail to update their beliefs about their ability or future performance. This is similar to the finding that gyms and other consumer services take advantage of biases of their customer groups when setting contracts and prices (DellaVigna and Malmendier, 2006). The attractiveness of convex pay schemes to overconfident employees is clear: by overestimating their likely performance, these employees believe they will earn more than they would in a typical linear pay scheme where pay does not accelerate as performance increases. For this argument to be robust, overconfident employees must not update their beliefs as to their ability, or must do so slowly. However, scholars know very little about the extent to which overconfident employees update their beliefs in the face of either persistent feedback about actual performance, or lower wages earned by choosing a job environment with a convex incentive plan. In our study, we allowed experimental subjects facing a standard multiplication task to choose how they wanted to be compensated: via a linear piece rate, or via a convex payout schedule that paid them more per correct answer as their productivity increased. The choice continued over nine rounds. We tracked the choices of the subjects, whether their choice of scheme was correct (in that it maximized their pay), and their level of confidence measured in a number of different ways. We used two initial periods where all subjects were assigned the linear piece rate in order to gauge subject skill at multiplication, and to set individual convex payoff functions so that subjects expecting to perform at a similar level as the initial periods would rationally have a slight preference for the linear pay scheme. Additionally, in order to control for incentive effects, subjects in our control treatment were randomly assigned a pay scheme in each non-practice round, and their performance was compared to that of subjects who were given a choice of pay schemes. 3 We considered introducing the choice of a flat payment to the experiment, since this scheme might be most attractive to highly underconfident subjects. However, Dohmen and Falk (2006) looks expressly at the choice between a flat wage and a piece rate and finds no correlation with confidence, and the introduction of a flat wage would introduce additional confounds and complexity. We therefore decided to look only at performance-based incentives. [5] Our results are striking. Subjects who are highly overconfident, as measured by their performance expectations on the task, are 45 percentage points more likely to incorrectly choose the convex scheme. These mistakes cost the subjects 15% of their payoff in these rounds. We also find qualitatively similar results for other measures of overconfidence, such as results from an independent self-reported measure of a subject’s propensity for relative overconfidence. Incentive effects could not explain our results; subjects who chose the convex scheme did not perform any differently from subjects who were randomly assigned the convex scheme. However, subjects who choose the linear scheme over the convex scheme perform 8% worse than subjects randomly assigned to the linear scheme, suggesting that offering only convex schemes in some work environments could help “sort away” employees who lack motivation. Furthermore, the subjects who choose the linear scheme in all six periods, and perform the worst relative to their initial ability, are also somewhat more likely to be underconfident. Therefore, overconfident subjects may be more likely to maintain motivation throughout the task. We examined a large number of demographic or personality predictors of overconfidence with limited results; only being male, extroverted, predicting a high future salary, or desiring a career in management predicted overconfidence on the task. Interes