Why Do Firms Use Non-Linear Incentive Schemes? Experimental Evidence on Sorting and Overconfidence - Ian Larkin and Stephen Leider

http://bit.ly/bWn6gN

Executive Summary:

The use of “non-linear” performance-based incentive contracts is very
common in many business environments. The most well-known example is
salesperson compensation, though many other types of performance-based
pay, including stock options, bonus systems based on defined metrics,
and pay based on subjective performance, often exhibit non-linear
characteristics. Research has demonstrated that non-linear incentives
are highly distortionary because employees manipulate their work in
order to maximize their pay. While some scholars have recommended that
companies stop using non-linear incentives, little research has been
done to investigate the possible benefits of non-linear schemes. In this
paper, HBS professor Ian Larkin and Ross School of Business professor
Stephen Leider (HBS PhD ‘09) explore the role that the behavioral bias
of overconfidence may play in explaining the prevalence of non-linear
incentive schemes. They conclude that the linearity or non-linearity of
an incentive system could play an important role in sorting employees
according to their level of confidence; in addition, there may be three
possible benefits to having overconfident employees. Key concepts
include:

• First, overconfidence is valuable for certain job functions; for
  example, salespeople lose deals much more frequently than they win them,
  and being overconfident may help them be effective despite the many
  failures they go through.


• Second, absent non-linear contracts, employers and overconfident
  employees may have a difficult time agreeing to a compensation scheme in
  the first place. Non-linear systems allow employers and employees with
  fundamentally different beliefs form compensation agreements.


• Third, the non-linearity of an incentive system may allow firms to
  lower their wage bill. A convex scheme, for example, may allow firms to
  take advantage of overconfident employees’ systematic and persistent
  bias toward believing they will perform well.


• The study confirms recent findings in psychology literature that
  overconfidence is not an individual trait so much as a trait around a
  specific task.