The multifaceted nature of incentives

Between 1978 and 1984, the output of the Chinese agricultural sector increased by more than 61%. This impressive performance was largely due - 78% to be precise - to the adoption of an incentive system that rewarded individual responsibility. Under the 'Four Modernisations' called for by Deng Xiaoping in the late 1970s, agriculture was de-collectivised. This introduced a new system in which the responsibility for the harvest no longer lay with the 'production team' but with the individual worker. The state assigned annual production quotas to each farmer with the understanding that all surplus produce would remain at his disposal. This new system set up a true pay-for-performance scheme in which the surplus crop was used to proportionally reward the efforts of the individual worker. We saw in last week's Mind the Economy the benefits of such an incentive system but also the problems associated with it. Problems that mainly concern inefficient risk-sharing and the difficulty of measuring performance in all those cases where the job involves different tasks. With the fixed remuneration in force in the Chinese agricultural system before the reform, even in the case of a bad harvest due to unexpected climatic events, for example, Chinese farmers could still count on a sufficient income for their livelihood. In this case, the risk fell entirely on the community. With the new system, on the other hand, this risk falls mainly on the individual farmer. And this generates higher costs and inefficiencies. A second problem with incentive contracts arises from the fact that many jobs have a multitasking nature, i.e. they consist of a variety of tasks. A teacher must be able to explain well in order to make himself understood by his students, he must also be able to switch on and keep their attention, he must take an interest in the different situations of his students, he must also continually update himself and be able to use new teaching technologies. Rewarding him only on one of these dimensions, perhaps the easiest to measure, such as the number of refresher courses attended, would run the risk of inducing him to invest most of his time in this activity, thus subtracting precious resources from the other equally important aspects of his work. In all those cases where multitasking is present, the use of incentive contracts may produce dysfunctional and even counterproductive results.

In order to mitigate these problems, in practice it is often preferred to resort to other forms of incentives based, for example, on subjective evaluations by direct superiors or the possibility of promotions and career advancement.

Subjective evaluations, on the one hand, have the advantage of being able to provide a more complete picture of an individual worker's performance by placing his or her results in a more precise context, comparing them with those of colleagues who have worked under similar conditions and taking into account other factors that are difficult to measure objectively. On the other hand, however, such evaluations have the defect of presenting a high degree of discretion. This discretion can lead the employer, for example, to systematically underestimate performance determined by the need to save on the cost of additional remuneration. Workers, then, may be driven towards inefficient forms of captatio belevolentiae, in order to curry favour with the boss. Finally, subjective evaluations are vulnerable to systematic distortions. Particularly relevant in this respect are the so-called leniency bias - i.e. a systematic reluctance to evaluate even the worst workers negatively - and the centrality bias - which, on the other hand, leads supervisors to reduce the variability of individual judgements, flattening them towards a central value that they consider representative of the majority of workers.

In the case of promotions, however, one considers not so much the absolute performance of individuals but their relative performance. One tries to ascertain how much each worker was 'better' or 'worse' than the others with respect to some desired objective. This simplifies the evaluation process because it is certainly easier to create a ranking than to assign precise values to the performance of each individual worker. Promotions are used for many different reasons. Mainly to get the 'best' workers to occupy positions of responsibility so that their skills can produce the maximum benefit for the organisation. One implication of this process of allocating workers to different rungs of the organisational hierarchy is that the prospect of promotion exerts an incentive effect. Empirical evidence shows that this effect is proportional to the benefits of obtaining the promotion and that these benefits are usually the greater the greater the number of those who aspire to the same promotion. It has also been seen that the competition to award promotions, in order to exert the incentive effect, must be a fair competition. If, in fact, one of the candidates has more initial chances of being promoted than the others, this asymmetry would reduce the motivational drive generated by the tournament. Even fair tournaments, however, can have negative side effects. The main one is related to the fact that they may generate an excessive level of competitiveness among colleagues and this may undermine their willingness to cooperate and may jeopardise the smooth functioning of working groups.

This last aspect of teamwork represents a further challenge to the logic of incentives. The methodologies we have seen so far in fact focus on performance measures, objective or subjective, but always calibrated at the individual level. In the case of group work, on the other hand, it can be very complicated to precisely identify the individual contribution to the collective result. Consequently, traditional tools can lose much of their effectiveness. Since, especially in large organisations, teamwork is the rule, addressing and solving this problem is of great importance. The main problem when working in a team is that of free-riding. Since the benefits of my efforts will have to be shared among all the N members of the group, indiscriminately, this can discourage me from exerting more effort and even lead me to reduce it, with the expectation that others will do their part. If this mentality spreads among all colleagues, the end result of teamwork will be compromised. Empirical evidence on group incentives shows interesting results. Analyses conducted by Andrew Weiss on employees of a large pharmaceutical company ("Incentives and Worker Behavior," in Information, Incentives and Risk Sharing. Haig Nalbantian, ed. Towota, N.J.: Rowan and Littlefield, 1987) and by Daniel Hansen on workers in a financial company ("Worker Performance and Group Incentives: A Case Study. Industrial & Labor Relations Review, 51, pp. 37-49, 1997) show that group incentives actually work quite well with the only problem being that they tend to increase the productivity of the less productive workers while discouraging the more productive ones. It has also been shown that when workers can then choose whether or not to join a group incentive scheme both the less productive and the more productive members will choose not to join. In fact, the more productive workers will be able to earn more with an individual remuneration scheme while the less productive ones will prefer to avoid group incentives in order to escape excessive pressure from other colleagues. A particular form of group incentive is profit-sharing. Economic models tend to describe this practice as inefficient especially in large enterprises. Why should an individual worker work harder knowing that he or she will only enjoy a small fraction of any increased profits? Data show, on the contrary, that the logic of profit-sharing instead works very well. The reasons are varied and not yet fully understood. There are those who explain this by considering the effect of 'peer pressure', i.e. the impetus exerted by group members who check each other's commitment and possibly punish those who slack off through informal sanctions. With this logic in mind, in February 1995, after a long period of disappointing performance in terms of flight punctuality and accounts in the red, Continental Airlines decided to introduce an incentive scheme promising a monthly bonus of $65 per employee if the company was among the top five in the industry for flight punctuality in that month. The number of workers covered by the new scheme was then around 35,000. A losing bet by any economic model. Who would have decided to work harder and better if the possibility of getting the bonus depended on the individual choices of another 34,999 workers? Instead, the new plan was a success and helped to save Continental from imminent bankruptcy (Knez, M., Simester, D., "Firm-Wide Incentives and Mutual Monitoring at Continental Airlines", Journal of Labor Economics, 19, pp. 743-772, 2001).