Sorting and Incentive Effects of Pay for Performance: An Experimental Investigation

Abstract

Agency theory highlights losses in productivity that may occur when the interests of owners and employees are imperfectly aligned. Pay for performance has been proposed as a solution to this problem. Using a real—effort laboratory experiment with salient incentives, we compared pay—for—performance and fixed—salary compensation. The former achieved significantly higher firm productivity through both sorting and incentive effects. In particular, more productive employees selected pay for performance, and employees on average, regardless of their preferred compensation scheme, produced more under it. However, more risk—averse individuals were less likely to select pay for performance and less responsive to its incentives.