The Impact of Financial Incentives on Individual Performance: An Experimental Approach

Content

Abstract

List of Tables

List of Figures

1 Introduction
1.1 Scope of Research
1.2 Outline of the Thesis

2 Theoretical Background
2.1 Psychological Background
2.2 Economic Theory

3 Research Findings
3.1 Empirical Findings
3.2 Experimental Findings
3.3 Critical Acclaim and further Questions

4 Proposals for the Structure of an Experiment
4.1 Objective
4.2 Design
4.3 Organization
4.4 Subsequent to the Realization
4.5 Potentially occurring Challenges

5 Conclusions
5.1 Summary of the Results
5.2 Further Research Suggestions

Appendix A

Appendix B

References

Abstract

The thesis on hand is dealing with the impact of financial incentives on individual performance. For this, the perception of an experimental approach has been chosen. The target of the thesis is the development of the blueprint of an experiment to provide further research input on the effectiveness of financial incentives.

To do so, the theoretical background for studying this problem is introduced by investigating the psychological and economical approaches to analyze the topic. Additionally, empirical and experimental studies dealing with this issue are presented.

Based on those findings, the structure of an experiment to be carried out at university with students is developed and objectives, design and supplementary requirements for conducting this are discussed. Subsequent, suggestions for the analysis, reporting and possibly occurring challenges throughout the process of implementation are illustrated.

The design of the experiment is giving a verification of before detected findings of a non-linear correlation between incentives and performance. In contrary to standard economic models, the relation is not predicted to be monotonic, but S-shaped. For this perspective, not only performance on varying incentive levels is analyzed, but also performance if payments are absent. Furthermore, the influence of publishing the course of incentive levels in the beginning of the experiment, in comparison to a task-to-task announcement is investigated. An evaluation of this relation is undertaken by studying the impact of financial incentives on performance of three observation groups through two different exercises with varying incentive levels during a real-effort experiment.

List Of Tables

Table 1: Incentive Structure of the Experiment conducted by Ariely and Heyman

Table 2: Summary of described Experiments

Table 3: Structure and Compensation of Experimental Groups

Table 4: Advantages and Disadvantages of Laboratory Facilities

List of Figures

Figure 1: Conceptual Framework of the Effects of Monetary Incentives on Effort and Task Performance

Figure 2: Structure of Organismic Integration Theory

Figure 3: Illustration of the Crowding-Out Effect of Intrinsic Motivation

Figure 4: Illustration of the Backward Bending labor Supply Curve (own illustration)

Figure 5: Results of Experiments from Ariely and Heyman (2004) (own illustration)

Figure 6: Suggested Relation of Incentive Level and Individual Performance

Figure 7: Example for Counting Numbers Task

Figure 8: Schematic Representation of Sliders

Figure 9: Example for Slider Task

Figure 10: Example for Matrix Task

1 Introduction

Many jobs are today paid via performance-based payment or at least have a component including financial payments based on individual performance. Especially, as ones performance is comparably easy to investigate, financial incentives dependent on visible achievements seem useful and practicable and in consequence are multiply used in today’s society. This means, that numerous employees, especially at a particular level (Managers) or with a substantial part of identifiable success (Sales, Consulting) are rewarded for their effort based on observed measures of performance. The intention behind performance-based compensation is to stimulate individuals to increase their motivation and effort spent on tasks, and hence their output, or in other words, profitability for the company. By using this way of payment, special incentives are placed and a change in ones behavior is intended to be reached for receiving the maximum possible outcome for the company.

On the other hand, the usage and effectiveness of financial incentives is not always seen as a positive instrument at all. The application of those tools and resulting behavior changes are seen as one of the major reasons for the financial crisis beginning in 2007¹. Wrong incentive setting for the employees and hereby misleading behavior of the staff yielded to specific behavior which lead to a fundamental crash of the world economy and threw the world into a global recession.

After those incidents, the mode of functioning of financial incentives and the most favorable usage of this motivation instruments came forcefully to the spotlight. Especially, comparably high “bonus payments” for bankers were in consequence of billions paid by governments for bank rescue and avoiding a collapse of the global financial system publicly discussed.

1.1 Scope of Research

The existing and fundamentally logical point of view on incentives is that incentive payments lead to increased motivation which resulted in higher performance of an individual. Furthermore, a positive correlation between incentives and performance is supposed to exist. This means, the higher incentives are, consequently the higher the motivation for conducting a task and followed by this the performance on a task can be expected to be.

The need of designing optimal contracts has always been a challenge, not only for companies. Economical research is delivering tools for understanding and minimizing problems arising through incomplete contracts between employer and employee. Previous to the design of optimal contracts, the efficiency of financial incentives needs to be investigated and proven.

Psychological research is laying the focus on analyzing motivation and performance of employees (e.g. Maslow, 1943; Herzberg et al., 1957; Deci and Ryan, 1985) and how the connection between intrinsic and extrinsic motivation can be affected through the application of different rewards.

From an economic perspective, the Principal-Agent-Theory is dealing with the relationship between employee and employer (e.g. Mirrlees, 1976; Grossmann and Hart, 1983; Holmstrom and Milgrom, 1987) and suggests solutions for minimizing the problem of asymmetric information and consequently providing optimal contracts for receiving maximum performance from the employee.

Theoretical approaches on applying small financial incentives in comparison to their absence have been analyzed (e.g. Frey, 1997; Bénabou and Tirole, 2003; Fehr and Falk, 2002) and supplementary, as incentives increase, the effects on individual willingness for achieving additional earnings has been investigated (e.g. Gilbert and Pfouts, 1958; Hanoch, 1965; Kahneman and Tversky, 1979). However, those models are hardly to be reviewed via empirical analysis as data are difficult to survey².

An experimental surrounding is predestined for the issue of analyzing and deepening findings on individual behavior in a tightly controlled environment and by this enriching economic research. So far, conducted experiments give useful information on the effectiveness of varying financial incentives (e.g. Gneezy and Rustichini, 2000a; Ariely and Heyman, 2004; Ariely et al., 2009; Pokorny, 2006) but do not come up with an explicit explanation on the width mode of functioning.

The thesis on hand is enlarging the branch of research by suggesting the design of an experiment for further analysis of the way financial incentives work. The approach of experimental research is chosen in consequence of the advantages in using experiments for analyzing people’s behavior and in testing suggested theoretic models under supervised conditions³.

A special perspective has been laid on lately conducted experimental studies to offer a current insight into the state of research. Additionally, the theoretical backgrounds on incentive effectiveness are introduced, which include psychological research on motivational development into economical optimization constraints.

The scientific relevance of this thesis is justified through the target of enhancing the branch of research of experimental economics by expending the perception on the effectiveness of financial incentives on individual performance. Consequently, it features assistance on promoting the understanding of individual behavior and principal-agent problems and enlarges the findings on analyzing the incentive-performance relation from an experimental perspective. By suggesting the design of an experiment to be conducted, the bases for subsequent analysis are being laid and successive research is relieved.

1.2 Outline of the Thesis

For the purpose of enlarging the research, this thesis is arranged in four parts:

First, an intuition on the theoretical research on the effectiveness of financial incentives is given. For this purpose, Chapter 2 provides an overview of the psychological literature, followed by an introduction of economic theory.

In Chapter 3, performed empirical studies by means of analyzing data sets and findings from realized experiments on financial incentives are described in more detail.

Based on the findings of those recently conducted experiments, a guideline for the body of an experiment for further research is introduced in Chapter 4. Therefore, results of the presented researches are compiled and the possible course of a graph expressing the relationship between financial incentives and individual performance is displayed. Questions that arose through conducted studies are pointed out and hypotheses for further analysis are introduced. Adapted from the hypotheses, the design of an experiment for enlarging the research is displayed. In connection with this, the requirements for the execution of the experiment are introduced and discussed. Suggestions for analyzing collected data within the experiment and reporting raised findings are listed. In the end, possible occurring challenges throughout the procedure of the experiment are mentioned and potential options for tackling them are suggested.

In Chapter 5, conclusions on the introduced analysis are drawn and expected research findings as well as further research areas are pointed out.

2 Theoretical Background

The analysis of individual performance and effort by empirical and experimental research is one important point to achieve results helping to understand the mode of functioning of financial incentives. A second point is the bedding of those results with theoretical backgrounds or models. In psychological research, the connection between experimental and theoretical research is (so far) closer than in economics, where the spotlight more relies on theoretical and empirical research. “Economics for the last forty years and more is strongly theory-based. Acceptable economic theories must be fully developed from preestablished first principles, and must relate specifically to the core micro theory” (Friedman and Sunder, 1994, p.133).

illustration not visible in this excerpt

Figure 1: Conceptual Framework of the Effects of Monetary Incentives on Effort and Task Performance⁴

As drawn in Figure 1, effort is dependent on Motivational Mechanisms and varying specific factors of influence (such as personal skills, task difficulty or environmental variables). Monetary incentives can influence individual motivation, through this impact effort, and consequently task performance. As performance on a task is heavily dependent on individual factors of influence which are difficult to appreciate upfront, theoretical constructs focus on analyzing motivation and effort (see Maslow, 1943; Herzberg et al., 1957; Deci and Ryan, 1985; Frey, 1997; Bénabou and Tirole, 2003). In the following, the terms and definitions “effort” and “performance” are used simultaneously, as this is most practicable for the analysis. Nevertheless, the differentiation as shown in Figure 1 is important to know and should be kept in mind by the reader.

In the first part of this chapter, an introduction into the psychological approach of analyzing individuals’ motivation (and by this one’s performance) is given.

The second part of this chapter lays the focus on the theoretical research economists contributed to the question of how financial incentives influence ones behavior. And continues on how the problem of optimizing individual preferences can theoretically be solved by using specific mechanisms.

2.1 Psychological Background

Based on the close interaction between experimental and theoretical analysis in psychology, a considerable background on this research area has been built up. Numerous theoretical models on the effects of financial incentives on individual performance have been delivered. The main focus of research is relying on analyzing the effects, incentives exercise on intrinsic motivation and in which way this interaction influences individual motivation and performance. One focus of this subchapter relies on the relationship of effort on a task and the development of this concerning individual motivating factors.

In psychology the view on individuals’ performance is biased by two factors. One is being stimulated by a motivating factor from outside (e.g. rewards, positive feedback), namely extrinsic motivation, and the second one is performing a task from an inner (intrinsic) motivation. Financial incentives impact an individuals’ motivation and the performance of the recipient. However, the effects are not determined and can work in a positive as well as a negative direction. In psychological literature, a general contention in many textbooks and journal articles is that rewards can be harmful to an individual's intrinsic motivation and by this a crowding-out of overall motivation can take place (Deci, 1975; Deci and Ryan, 1985; Lepper and Greene, 1978).

As studies (and theoretical constructs) are more focused on the effects on intrinsic motivation, empirical analysis must be reviewed in a different way than comparable economic research. Conducted meta-analysis provided no definite results in the way of functioning of extrinsic motivating factors⁵ (compare Rummel and Feinberg, 1988; Wiersma, 1992; Tang and Hall, 1995; Cameron and Pierce, 1994; Deci et al., 1999; Eisenberger and Cameron, 1996). Positive as well as negative impacts have been detected and depending on the analysis, the results differ accordingly. There is little doubt about external factors impacting individuals’ motivation, but the modality is questionable and not definitely obvious.

The Relation of Extrinsic Factors and Individual Effort

As early as 1908 Yerkes and Dodson (1908) analyzed the effects of extrinsic factors on individual effort. For this, the authors investigated the connection between activation and performance throughout an experiment with mice which were rewarded depending upon their behavior on learning discrimination between different grey papers. Modeling the experiment helped to analyze the connection between motivation and performance. The authors found a relationship between arousal and performance which can be described as an inverted U- shaped function with a peak after which the mice had a slower or even decreasing learning curve. Those findings are today known as the so-called “Yerkes-Dodson” law. The point of the optimum of arousal is expected to vary depending on the task, the individual's personality, and the individual's experience with the task. Since arousal is closely connected to motivation and performance, the “Yerkes-Dodson” law implies that increases in motivation beyond an optimal level can, in some situations, produce a supra-optimal level of arousal and hence decrements in performance (compare Ariely et al., 2009, p.452).

Follow-up experiments showed, that increased motivation can limit individuals’ focus of attention on a variety of dimensions, together with the extent of the solution set people consider (e.g. Easterbrook, 1959) and caused by this, results in a negative effect on performance⁶ (see Ariely et al., 2009, p.453). By showing that a negative impact on performance was realized through the introduction of monetary incentives for tasks that involved problem-solving, McGraw and McCullers (1979) supported the theory of this mechanism.

One explanation for those effects can be seen in large incentives to occupy the mind and concentration of the job holder with thoughts about her future and if she will get the payment and her regrets if not, are diverting her from the task at hand. Further explanations for negative effects of increased incentives on individual effort might be, that increased incentives can cause people, involuntarily, to intentionally think about the task and by this shift control of behavior from “automatic” to “controlled” mental processes although it is well known that controlled processes are less effective for tasks that are highly practiced and automated⁷ (see Ariely et al., 2009, p.453).

Motivation Theories

At least three historical theories of motivation have dampened the attention of psychologists in investigating the relations between performance, performance evaluation, and pay (compare Rynes et al., 2005, p.574): Maslow’s hierarchy of needs theory (Maslow, 1943), Herzberg’s motivator-hygiene theory (Herzberg et al., 1957), and Deci and Ryan’s Self Determination Theory (Deci and Ryan, 1985)⁸. A major implication of all three theories is that monetary rewards are not a major determinant of work motivation, except perhaps for employees at low income levels.

In Maslow’s need hierarchy theory (1943) human needs are arranged in a hierarchy of pressure that is biological or instinctive in nature. Consequently, a need that is denied acts as a primary motivator; while a need that is satisfied has less motivational impact.

The base of Maslow’s hierarchy is built upon physiological (food, sleep) and safety (e.g. housing) needs - needs which are most effectively settled by money. As soon as these basic needs are satisfied, individuals are expected to focus on “higher” needs, such as love, esteem and self-actualization. Maslow hypothesized that these higher-order needs are rather to be met through engagement in considerable work than through monetary rewards (compare Rynes et al., 2005, p.574).

Herzberg’s motivation-hygiene theory (1957) focuses on classifying factors that contribute to either satisfaction, or dissatisfaction at work. For this, the factors involved in producing job satisfaction (and motivation) are separated and diverse from the factors that lead to job dissatisfaction. He differentiates between Motivators (e.g. challenging work, recognition) and Hygiene factors (e.g. job security, salary). Motivation factors are needed in order to motivate an employee to increase her performance actions. To ensure an employee not to be dissatisfied, Hygiene factors are needed. Herzberg saw hygienic needs as being driven by people’s “animal nature” (p.9) and posited that money was more likely to be a “hygienic” factor than a satisfying or motivating one. Thus, Herzberg believed that money played a role in creating or reducing dissatisfaction, but not in contributing to satisfaction or motivation (compare Rynes et al., 2005, p.574).

Deci and Ryan (1985) argue that when effort is applied in exchange for pay, pay takes on a controlling aspect that threatens the individual’s need for self-determination. Placing importance on monetary rewards is likely to decrease people’s intrinsic interest (for instance interest in the work itself), consequently dampening a potentially powerful alternative source of motivation. Deci and Ryan describe intrinsic motivation as “based in the innate, organismic needs for competence and self-determination” (p.33), and argue that it occurs in its purest form when “a person does an activity in the absence of a reward contingency or control” (p.35) (compare Rynes et al., 2005, p.575). This theory, combines different motivation factors and contributed largely to impact on follow-up analysis by economical research and is illustrated in greater details below.

Self Determination Theory

The Self Determination Theory (SDT) (Deci and Ryan, 1985) focuses on the individual needs for competence and self-determination. From this perspective, a person's intrinsic motivation is affected by changes in feelings of competence and self-determination. Linked with the SDT are the Organismic Integration Theory (OIT) and the Cognitive Evaluation Theory (CET). This literature claims, that the introduction of monetary rewards decreases task-specific intrinsic motivation under identifiable conditions. One consequence of the crowding-out of task-specific intrinsic motivation is that monetary rewards for performing a task may decrease the effort that is put onto the task.

Within SDT, Deci and Ryan introduced a subtheory, described OIT, to specify the different forms of extrinsic motivation and the related factors that either promote or hinder internalization and combination of the regulation for these behaviors. Figure 2 shows the different ways of motivation due to the OIT.

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¹ For further reading on the financial crisis of 2007 refer to the literature (for instance Ambachtshee et al. (2008)) or to the internet.

² Nevertheless, studies analyzing the implementation of performance-based payments in comparison to flat- payments in companies are on hand and presented in the course of this thesis.

³ For an introduction into the development of Experimental Economics and for a discussion on advantages and disadvantages of this discipline please refer to the literature (for instance Friedman and Sunder (1994) or Kagel and Roth (1997)).

⁴ adapted from Bonner and Sprinkle, 2002, Fig.1

⁵ The meta-analysis tool is a relatively new statistical method that allows researchers to summarize the results of many different experiments conducted on a specific topic by different scientists at different points in time by estimating the effect size of treatments such as incentive systems as a percentage of a standard deviation change in performance due to the strategy being investigated (see Condly et al., 2003, p.46).

⁶ This can be especially harmful for tasks involving insight or creativity (both require a kind of open-minded thinking that enables one to draw unusual connections between elements)

⁷ Compare Langer and Imber, 1979; Camerer et al., 2005

⁸ For further reading please refer to the psychological literature on motivation (for instance Miner, 2005; Latham, 2006). Considerable motivation theories for further reading are especially: Vroom (1964), Atkinson (1957), Weiner (1986), Festinger (1978), Hull (1943), Csikszentmihalyi (1975), Locke and Latham (1990).