PLAYING FOR KEEPS: PAY AND PERFORMANCE IN THE NBA

I. INTRODUCTION A basic insight of agency theory is that properly designed incentive contracts can align the interests of agents with those of the principal, and recent empirical work shows that workers do indeed respond to financial incentives. (1) Contractual incentives, however, are not the only force motivating workers. Workers also have incentives to vary effort at different points of their contract cycle--to increase effort just before a new contract is signed to lock in a more lucrative deal and then reduce it after a multi-year contract is secured. These types of contract-related incentives create clear moral hazard problems but have received little empirical attention. The motivating hypothesis in this paper is that imperfect information and multi-year contracts create an implicit incentive for workers to strategically alter effort over the contract cycle. In the year prior to signing the contract (their "contract year"), workers may exert above-average effort to convince employers that they are high quality and thus raise long-term compensation. Once the contract is signed, however, workers may exert less effort because wages are effectively independent of contemporaneous performance. An empirical difficulty is that this moral hazard may be obscured by two factors--a selection effect may lead only high-quality workers to receive contracts and career concerns may provide additional incentives and dampen the post-contract decline. (2) This paper employs a unique dataset for professional basketball players in the National Basketball Association (NBA) from 1988 to 2002 to examine the contract-related incentive effects. The data include contract information (year signed, length of contract, and value of contract) for every active player in 2000 and performance measures (points scored, rebounds, assists, etc.) throughout each player's career. Contract-related incentive effects are estimated from changes in individual performance over the contract cycle: if performance systematically improves just before signing a new contract and falls afterward, some of the fluctuation is likely due to contract-related incentives. I also examine the traditional link between pay and past performance, which is necessary for these types of incentives to be relevant. The critical advantage of this data is the detailed information on individual performance, individual contract status, and individual pay. (3) In contrast, previous work on individual incentives, for example, Lazear (2000), Paarsch and Shearer (2000), and Shearer (2004), studied changes infirmwide compensation plans, while the empirical literature on executive pay and performance, for example, Murphy (1985, 1986), Jensen and Murphy (1990), Gibbons and Murphy (1992), Kaplan (1994), and Hall and Liebman (1998), typically examined the link between individual pay and firm performance. The individual-level data constructed here have the critical variation across individuals, which is needed to identify the impact of these contract-related incentive effects. The empirical work begins with a test of the link between pay and performance, which is necessary for contract-related incentives to be operational. Not surprisingly, better performers in the NBA are rewarded with higher salaries and longer contracts. More relevant to the incentive issue, players are strongly rewarded for improvements in performance in their contract year. A one-point increase in a player's scoring average, for example, is associated with an annual salary increase of over $300,000. This link provides the crucial motivation for the hypothesis that players will exert additional effort in their contract year to lock in the better contracts that they expect to follow. The data then provide strong evidence of contract-related incentive effects as overall performance does in fact improve relative to a player's long-run average in the contract year and then declines after a long-run contract is signed. …