Pay and incentives

Deregulation and managerial compensation are two important topics on the political and academic agenda. The former has been a significant policy recommendation in light of the negative effects associated with overly restrictive regulation on markets and the economy. The latter relates to the sharp increase in top executives’ pay and the nature of the link between pay and performance. To the extent that product-market competition can affect the incentive schemes offered by firms to their executives, the analysis of the effects of competition on the structure of compensation can be informative for policy purposes.

The escalation in chief executive officer (CEO) pay over recent decades, both in absolute terms and in relation to the earnings of production workers, has generated considerable attention. The pay of top executives has grown noticeably in relation to overall firm profitability. The pay gap between CEOs in the US and those in other developed countries narrowed substantially during the 2000s, making top executive pay an international concern. Researchers have taken positions on both sides of the debate over whether the level of CEO pay is economically justified or is the result of managerial power.

A good boss can have a substantial positive effect on the productivity of a typical worker. While much has been written about the peer effects of working with good peers, the effects of working with good bosses appear much more substantial. A good boss can enhance the performance of their employees and can lower the quit rate. This may also be relevant in situations where it is challenging to employ incentive pay structures, such as when quality is difficult to observe. As such, firms should invest sufficiently in the hiring of good bosses with skills that are appropriate to their role.

Do workplace programs help reduce worker sickness absence? Many programs are based on the principle that the employee’s decision to report an absence can be influenced if it is costly to be absent. Firms can reduce absenteeism by implementing broad programs, including performance pay, general improvements of working conditions, and strengthening workers’ loyalty to the firm. Specific programs, such as grading partial absence, seem to be effective at reducing long-term absences. However, firms will be less inclined to implement such programs if they can shift the financial burden to social security programs.

Organizational characteristics and management styles vary dramatically both across and within sectors, which leads to huge variation in job design and complexity. Complex jobs pose a challenge for management and workers; an incentive structure aimed at unlocking workers’ potential can effectively address this challenge. However, the heterogeneity of job complexity and the inherent difficulty in devising a correct set of incentives may result in misalignment between job demands and incentivized behaviors, and in complaints by employers about the lack of skilled workers.

The majority of individuals released from prison face limited employment opportunities and do not successfully reintegrate into society. The inability to find stable work is often cited as a key determinant of failed re-entry (or “recidivism”). However, empirical evidence that demonstrates a causal impact of job opportunities on recidivism is sparse. In fact, several randomized evaluations of employment-focused programs find increases in employment but little impact on recidivism. Recent evidence points to wages and job quality as important determinants of recidivism among former prisoners.

Workers can contribute to total firm production directly through their own output or indirectly through their influence on the output of co-workers. Workers with positive productivity spillover effects cause individuals around them to perform better and increase overall team production. In contrast to the “peer effects” literature, workers with positive productivity spillovers may not be the workers with the highest levels of personal output. Such productivity spillovers are important for team success even though they play only a minor role in determining worker pay.

Recent studies show that even irrelevant relative pay information—earnings compared to the past or to others—significantly affects workers’ willingness to work (labor supply) and effort. This effect stems mainly from those whose pay compares unfavorably; accordingly, earning less compared to others or less than in the past significantly reduces one’s willingness to work and effort exerted on the job. Comparing favorably, however, has mixed effects—with usually no effect on effort, but positive or no effects on labor supply. Understanding when relative pay increases labor supply and effort can thus help firms devise optimal payment structures.

To align employees’ interests with the firm’s goals, employers often use performance-based pay, but designing such a compensation plan is challenging because performance is typically multifaceted. For example, a sales employee should be incentivized to sell the company’s product, but a focus on current sales without rewarding the salespeople according to the quality of the product and/or customer service may result in fewer future sales. To solve this problem, firms often increase the number of metrics by which they evaluate their employees, but complex compensation plans may be difficult for employees to understand.

The gender wage gap is largely due to men and women holding different kinds of jobs. This job segregation is partly driven by gender differences in careers in corporate hierarchies. Research has shown that the careers of men and women begin to diverge immediately upon entry into the labor market and that subsequent career progress exacerbates the divergence. This divergence of career progress explains a large part of the gender wage gap. Understanding how and why the careers of men and women differ is necessary to design effective policies that can reduce the gender differences in hierarchies.