Pay for Performance: Motivation and Selection Effects

Abstract

Does pay for performance increase productivity? The answer has to be, "Yes, but..." Larger ex gratia payments, bonuses and commissions do motivate employees to put in more effort, but at the same time they provide an incentive for less qualified people to carry out activities that are rewarded by performance-related pay. Consequently, the overall effect of a greater focus on performance is ambivalent: if the motivational effect dominates, output per employee will go up; if the selection effect has the upper hand, output per employee will fall. The trick is to create a compensation structure that exploits the motivational potential of monetary incentives without encouraging inefficient activity. In this chapter we use an empirical study of employee suggestion plans in more than 1,400 companies to show how this is possible. We find that companies that pay higher rewards for suggestions do not receive more useful ideas. The quality of suggestions does not rise because a relatively larger number of less qualified employees take part in generating the ideas. Companies that pay lower amounts but which focus these payments on the best suggestions achieve much greater cost savings. The significance of the motivational and selection effects is not, of course, limited to suggestion plans.