Professors Ian Larkin, Lamar Pierce, and Francesa Gino have an interesting new conceptual paper about pay for performance systems. They use psychology to provide a more nuanced look at how pay for performance systems might affect behavior. According to the authors, agency economists have long been the driving force behind pay for performance, working on the assumption that such compensation systems increase effort on the part of workers. However, they add some caveats based on a deep understanding of human psychology.
First, the authors argue that people naturally compare themselves to others in the workplace, and perceived inequity through wage comparison can have negative effects. Second, they note that overconfidence bias affects many individuals, and that may exacerbate perceived inequity. Moreover, people may choose jobs for which they lack the appropriate skills due to overconfidence bias. Finally, psychological theory suggests that individuals tend to engage in more risk-taking behavior if they perceive themselves to be in a "loss position" as opposed to a "gain position." Thus, the authors argue that if some outside factor has made it quite difficult for them to reach their personal income target that they have set for themselves (put them in a loss frame relative to their original goals) , they may start taking excessive risks in an effort to recoup their losses.
What should be done about these biases? Among other things, the authors argue for more use of team-based compensation systems. Of course, team-based systems have their own handicap, namely that we have the potential for free-riding to occur. In the end, I don't think we can ever find the perfect compensation system, but we do have to have a thorough understanding of the limitations and unintended consequences of our compensation systems, which this paper does help us comprehend. Beyond that, we have to consider the non-financial elements of motivation that are critical to having a productive workforce.