Design of Incentive Schemes within Firms: Bonus Systems and Performance Evaluations

Principal Investigators: Dirk Sliwka, Bernd Irlenbusch, Patrick Schmitz

With the desire to align individual and company interest, pay-for-performance schemes, such as annual bonus plans, have been widely adopted by firms in the last decades. In the light of the recent economic crisis it has become obvious that misspecfied incentive plans can cause companies and even markets to fail. The aim of this project is to develop recommendations for the design of compensation structures making use of recent advances in behavioral economics that help to develop a more realistic model of economic actors.Social preferences and cognitive limits have now been extensively studied in experiments but evidence on how they relate to success or failure of incentive schemes is rare. For instance, even though incentives on team or firm performance frequentiy accompany individual incentives, there is still a lack of empirical research on how combined performance measures influence cooperation. Moreover, most bonus schemes in practice rely to a strong extent on subjective performance appraisals that are highly likely to be affected by preferences for fairness, honesty and trust. Since subjective ratings are usually based on unverifiable information, supervisors may distort them according to personal interests. Designing and testing incentives that align individual with company's interests are at the core oft his project.