The logic of incentives in the face of the complexity of work. This is why practice is so different from theory

'Incentives are the essence of economics'. So wrote the Chicago economist Canice Prendergast some time ago in the prestigious Journal of Economic Literature,. The centrality of incentives in economic thought and particularly in the organisational sphere is justified by the fact that their use proves to be fundamental in solving two important problems that plague labour relations. The first is that of motivation and the second is that of opportunism. The first issue concerns the fact that work generally represents a source of disutility. "Work makes you tired!" it is said. This means that in order to convince a worker to do what is needed for the organisation in which he is placed, he must be persuaded to bear the cost of what he is asked to do. A cost that generally increases as the level of commitment increases. The second theme, that of opportunism or, more technically, moral hazard, stems from the fact that the interests of individual workers and those of their employers are generally not perfectly aligned. Typically, one imagines that an employer prefers on the one hand to collect higher profits and on the other hand to pay lower wages, while a worker aims at higher wages and minimising effort and fatigue. This conflict of interest is aggravated by the fact that a strong information asymmetry exists between the two parties. The employer can, in fact, only imperfectly verify the level of effort put in by the worker. It is possible, for example, to ascertain his presence in the workplace, but it is very complicated to measure precisely how much effort he is actually putting in and how much enthusiasm, creativity, willingness to communicate and cooperate with colleagues. This is information known only to the worker. It is the existence of this information asymmetry that creates room for opportunistic actions by workers. They could, in fact, be induced by the difficulties of verifying their behaviour, to do shirking, as they say in these cases, that is, to 'beat around the bush'. Traditionally, managers who are trained in business schools halfway around the world learn to imagine: "Management institutions and practices (...) designed as if people were exclusively motivated by their pure self-interest and were rather skilled and totally unscrupulous in pursuing their goals. This model of human behaviour (...) in fact considers the possibility that people are particularly adept at finding ways through which they can promote their interests and that they will act in a fundamentally amoral manner, ignore rules, transgress agreements and use fraud, manipulation and deception if they realise that this can be to their advantage' (Milgrom, P., Roberts, J., Economics, Organisation and Management. Prentice Hall, 1992, p. 42).

The systematic use of incentives can be an effective answer to both of these problems, that of motivation and that of opportunism. Compensation schemes, in fact, are nothing more than mechanisms through which employees receive remuneration for their work and, in general, bonuses or additional shares that are made contingent upon the achievement of certain pre-set objectives. Technically we speak of 'incentive contracts'. The remuneration system incorporated in incentive contracts is based on the logic of pay-for-performance, the traditional 'piecework'. The additional remuneration is tied to the performance of the employees, both to motivate them and to give them responsibility, thus inducing them to exert the level of commitment desired by the employer.

The main drawback of incentive contracts is that they result in inefficient risk-sharing between employer and employee. While it is true that better performance is determined by higher levels of commitment, it is also true that there may be cases in which, despite a high level of commitment, this is not followed, for reasons beyond the employee's control, by sufficiently positive results. This implies that if remuneration is conditional on performance, it may happen that a worker who has made a considerable effort is not financially recognised because the expected results, for reasons beyond his control, have not arrived. If that worker were paid a fixed or hourly wage, the risk associated with disappointing results would fall entirely on the company. If, on the other hand, he is paid through an incentive contract, then the worker will share, together with the employer, a certain share of that risk. This is a problem because generally, while companies are risk-neutral, workers tend to prefer prudence. So if we want to convince them to sign an incentive contract, we will have to pay them an additional sum. A real 'risk premium'. This results in a strong inefficiency, because in order to achieve the same performance as in the absence of information asymmetries, the employer will now have to pay higher wages by incurring higher costs.    

So far the theory. But what happens in practice? How do companies behave? A first question that is important to ask concerns the effectiveness of these incentive contracts in actually increasing the performance of workers. Edward Lazear, a Stanford economist, was one of the first to convincingly identify the link between incentives and productivity. In a major study published in 2000 in the American Economic Review, Lazear analysed data collected on three thousand workers between 1994 and 1995, the years in which the management of the Safelite Glass Corporation, a windshield factory decided to switch from the hourly wage scheme to the pay-for-performance system. The results that emerge from the data considered by Lazear are quite clear: the average level of productivity per worker grows over the following 19 months by 44%. Behind this growth are actually two different phenomena. Approximately half of the increase can be attributed to the effect of the new pay scheme on the commitment of workers (incentive effect), while the other half stems from the fact that the existence of this type of contract attracts new, more productive aspiring workers on average (screening effect). That is, the new contract serves as a 'filter' to keep out the less productive aspirants and attract the more skilled ones. The increased revenues from the new pay scheme are partly shared with the workers who now receive, on average, a 10% higher salary. The data also show an increase in the variability of productivity. When pay was determined on an hourly basis, the most ambitious workers had no reason to differentiate themselves from others. This is the case with contingent remuneration.

These results therefore show that incentive contracts increase productivity. This does not necessarily mean that their use is convenient for all companies. Because while productivity may increase, control and monitoring costs may also increase and, in some cases, there may also be negative effects on product quality.