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21 Apr 2010Working Paper Summaries

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

by Ian Larkin and Stephen Leider
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.

Author Abstract

Non-linear incentive schemes are commonly used to determine employee pay, despite their distortionary impact. We investigate possible reasons for their widespread use by examining the relationship between convex pay schemes and overconfidence. In a laboratory experiment, subjects chose between a piece rate and a convex pay scheme. We find that overconfident subjects are more likely than others to choose the convex scheme, even when it leads to lower pay. Overconfident subjects also persist in making the mistake despite clear feedback. These results suggest non-linear pay schemes may help companies select and retain overconfident workers, and may reduce the wage bill. 35 pages.

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