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When high-powered incentive contracts reduce performance: choking under pressure as a screening device

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  • Bannier, Christina E.
  • Feess, Eberhard

Abstract

Empirical and experimental papers find that high-powered incentives may reduce performance rather than improve it; a phenomenon referred to as choking under pressure. We show that competition for high ability workers nevertheless leads firms to offer high bonus payments, thereby deliberately accepting pressure-induced performance reductions. Bonus payments allow for a separating equilibrium in which only high ability workers choose high-powered incentive contracts. Low ability workers receive fixed payments and produce their maximum output which, however, is still below the reduced output of high ability workers. Bonus payments lead to a social loss which is increasing in the degree of competition. Our paper helps to explain why steep incentive schemes are persistent in highly-competitive industries such as investment banking, and why the observed performance sensitivity of CEO compensation is largely heterogeneous.

Suggested Citation

  • Bannier, Christina E. & Feess, Eberhard, 2010. "When high-powered incentive contracts reduce performance: choking under pressure as a screening device," Frankfurt School - Working Paper Series 135, Frankfurt School of Finance and Management.
    • Handle: RePEc:zbw:fsfmwp:135
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    References listed on IDEAS

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    More about this item

    Keywords

    Performance-related pay; screening; choking under pressure; competition;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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