The Effect of Incentive Contracts on Learning and Performance

1. The Effect of Incentive Contracts on Learning and Performance By: Geoffrey B. Sprinkle Presenter: Sara Aliabadi October, 2, 2008

2. Question How do incentive-based compensation contracts compare to flat-wage compensation contracts in motivating individual learning and performance.

3. Agency Theory Individuals must be able to use the information (feedback) provided for belief-revision purposes to improve future productivity. The firm must use incentive contracts to motivate individuals to exert effort and use feedback to improve performance.

4. Is Agency Theory True? Accounting studies (Arkes et al. 1986; Hograrth et al. 1991; Ashton 1990) indicate that performance-based contracts do not improve and they even can reduce learning and performance. Why? Because decision maker will focus on how well he is doing on the task instead of how efficient he is.

5. How does this study differ from prior studies? • Prior studies did not considered settings where the incentive contract is optimal and/or there is a significant role for learning. • As a result, it is unclear whether the results generalize to environment where both: • The provided information helps in productivity and, • The incentive contract motivate individuals to maximize total expected profit.

6. Background Many studies found no improvement as the result of incentive contracts. They even found negative results. Arkes et al. (1986) found fewer accurate judgments when there is incentive condition Ashton (1990) found insignificant difference in professional auditor’s performance when incentive is offered.

7. Background Continued Why prior studies didn’t find incentive effects? Incentive may divert a decision maker’s attention. (Baumeister 1984; Humphreys and Revelle 1984; Kanfer and Ackerman 1989; ………..) Extrinsic rewards may undermine an individual's intrinsic motivation to perform a task (Weiner 1980; Deci and Ryan 1985; Kohn 1993; Vogl 1994).

8. Background Continued Alternative explanation for prior research’s general failure to detect incentive effects: The incentive contracts chosen by researcher have rather weak incentive properties. The value of feedback provided to participants was unclear.

9. How do we fix the prior studies mistakes? In this study: Participants must solve a dynamic programming problem. Provided feedback allows participants to make better choices. The incentive-based contract theoretically motivates participants.

10. Hypotheses H1: Compared to individuals receiving a flat-wage contract, individuals receiving an incentive-based contract will exert more effort on the task. H2: Compared to individuals receiving a flat-wage contract, individuals receiving an incentive-based contract will perform better on the task.

11. Hypotheses Continued Prior research suggests that performance in the early periods of a cognitive task may not differ. When participants receive feedback and gain experience, the performance will change. H3: The performance superiority induced by the incentive-based contract will increase over the course of the experiment.

12. Task Description In each experiment, participants made a production (output quantity) decision for a single product in each of 60 periods. 60 periods were partitioned into 12 independent trails. Each trials consist of five consecutive periods. At the end of each period within each trial, participants could observe feedback.

13. Risk Preferences and Effort Measurement Performance is measured as the total profit a participant earned from making output decisions in each trial. (Table 1) Effort is measured as the amount of time a participant spent making output decisions in each trial.

14. Participants and Procedures • Forty undergraduate (sophomore and above) business students. • Participants were randomly assigned to one of the two compensation conditions (incentive-based or flat-wage). • Participants had to earn profit points by choosing a production quantity in each period. • Number of profit point earned depended on: • The production quantity participants selected. • The state of nature the computer selected.

15. Results • H1 is tested using an ANOVA. • H1 is supported. • Mean time spent per trial is higher for participants receiving the incentive-based contract. • Average time spent by participants in the incentive-based condition was 62.02 seconds and for participants in the flat-wage condition was 49.01 seconds. (Table 4) • The compensation condition main effect is statistically significant ( F= 10.87, P < 0.01)

16. Results Continued • H2 is supported by a significant compensation condition main effects where the mean profit per trial is higher for participants receiving the incentive-based contract. • Table 5 :average profit per trial was 203.48 points for incentive-based condition and 168.88 for flat-wage condition. • Table 6: the compensation condition main effect is statistically significant (F = 11.21, p < 0.0 ).

17. Results Continued • H3 is also supported. • Table 7: Indicates the relative superiority of the profit performance of participants receiving the incentive-based contract increased over the course of the experiment. ( F= 5.95, p < 0.02) • We found positive relation between time spent on the task and total performance.

18. Summary • Participants receiving the incentive-based contract spend more time on the task than participants receiving the flat-wage contract. • Also participants receiving the incentive-based perform better.

19. Contribution • Individual receiving incentive-based contract perform better if: • The form of incentive contract motivates profit maximization, • The feedback provided for belief-revision purposes helps individuals make better decisions. • Incentive-based compensation contracts increase the rate of learning and accelerate the learning curve. • Incentives increase both the duration and intensity of effort.

20. Limitation • This study used only one type of task and one type of incentive scheme. • This study did not consider the learning in workgroups and teams.