Heterogeneous Effects of Performance Pay with Market Competition: Evidence from a Randomized Field Experiment

It is well established that the effectiveness of pay-for-performance (PfP) schemes depends on employee- and firm-specific factors. Much less is known about the role of factors outside the firm. We investigate the role of market competition on the effectiveness of PfP. Our theory posits that there are two counteracting effects, a business stealing and a competitor response effect, that jointly generate an inverted U-shape relationship between PfP effectiveness and competition. Weak competition creates low incentives to exert effort because there is little extra market to gain, while strong competition creates low incentives as competitors respond more. PfP hence has the strongest effect for moderate competition. We test this prediction with a field experiment on a retail chain which confirms our theory and refutes alternative explanations.