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

Christina E. Bannier and Eberhard Feess ()

No 135, Frankfurt School - Working Paper Series from Frankfurt School of Finance and Management

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.

Keywords: Performance-related pay; screening; choking under pressure; competition (search for similar items in EconPapers)
JEL-codes: D86 J31 J33 (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-bec, nep-cta and nep-lab
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (39)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:fsfmwp:135

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