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could incorporate both narrow and broad measures into an employee’s compensation, paying attention to how the relative weights on the two measures will affect the employee’s on-the-job decisions.

Whatever measures are used in explicit incentive contracts, it is almost always the case that direct monitoring and subjective evaluation are used in tandem with the explicit contract. The role of such monitoring is often to offset the risk and multitask problems associated with the performance measures in the explicit contract. Since monitoring consumes valuable managerial resources, firms should also consider how the choice of performance measures will affect what activities will need to be directly monitored. If it is easy for the firm to monitor actions taken by one employee that are intended to reduce the performance of another, this favors the use of relative measures. If, on the other hand, it is easy for the firm to gain information regarding the common random factors affecting employees’ performance, these random factors can be filtered through monitoring without relying on relative comparisons.

DO PAY-FOR-PERFORMANCE INCENTIVES WORK?

There is considerable evidence that employees consider the effects on their compensation when making decisions.19 One series of studies examined simple jobs for which measures of on-the-job performance are easily available. As discussed in Example 12.3, Lan Shi documented large increases in productivity after Yakima Valley Orchards implemented a piece-rate-based compensation system. Harry Parsch and Bruce Shearer conducted a similar analysis using payroll records from a tree-planting firm in British Columbia. They estimate that tree planters were 22.6 percent more productive when paid on a piece-rate basis as compared to a fixed wage.20

It is somewhat more difficult to assess whether the use of incentive compensation increases productivity in complex jobs. Researchers have instead offered evidence suggesting that pay-for-performance incentives improve performance along measured dimensions. Martin Gaynor, James Rebitzer, and Lowell Taylor, for example, have studied incentives for physicians in an HMO network.21 Under the HMO’s contract, a physician’s pay increased by 10 cents for every $1.00 reduction in medical expenditures. Implementation of this contract led to a reduction in medical expenditures of 5 percent, and linking pay to measures of quality led to improvements along these quality dimensions. Health care quality is difficult to measure, however, and it is possible that the cost reductions and improvements in measured quality came at the expense of lower quality on unmeasured dimensions. In fact, it is relatively easy to find examples in which pay-for-performance compensation plans have destructive effects. For example, an Australian study found that employees help each other less and exert more individual effort when individual-based promotion incentives are strong.22 This and many other studies like it illustrate why it is difficult for firms to know whether they should use high-powered pay-for-performance incentives, especially when jobs are complex.

IMPLICIT INCENTIVE CONTRACTS

Jobs in which pay is tied to performance through some predetermined formula are the exception rather than the rule. For many jobs, such formulaic compensation would be counterproductive, for the reasons we explain above. This is why firms often rely on implicit incentive contracts, in which workers expect to be rewarded for

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their productive efforts, even if evaluations are subjective and no explicit rewards are written down. The primary advantage of implicit incentive contracts is the range of performance measures that can be incorporated. In an explicit pay-for-performance contract, pay is tied to a measure through a predetermined formula. This measure must be verifiable in case there is a dispute between the firm and the worker and the contract must be enforced by a third party such as a judge or an arbitrator. No such restrictions apply to implicit measures.

Many aspects of performance are verifiable, including the earnings of an investment bank, the number of patients seen by a physician, or the dollar value of goods sold by a salesperson. But other aspects of performance may be hard to measure or may invite counterproductive actions. Consider a firm that wants its employees to share knowledge. How would it measure “knowledge sharing?” If it based compensation on the number of written reports, this could motivate employees to write trivial reports. Ideally, firms would like to write incentive contracts that reward employees for sharing valuable information, but a third party would probably find it difficult to measure value. Hence, any explicit contract based on whether the employee shares valuable information will not be enforceable.

A supervisor, on the other hand, might easily determine whether an employee is sharing valuable information and the supervisor’s assessment could be incorporated into an implicit incentive contract. A firm may announce to employees, “Your bonus, raise, or promotion depends in part on whether your supervisor believes your infor- mation-sharing efforts were good, satisfactory, or poor.” As long as the firm and its employees have a similar understanding about what constitutes valuable information, such an approach can improve on explicit contracts. E-Land, a South Korean fashion retailer, provides an example. While suffering through a severe business slump in late 1998, the firm began asking its employees to post useful information on its Intranet. The quality of these tidbits, collected on an employee’s “knowledge résumé,” figures prominently in promotion and bonus decisions.23 The firm credits this practice with large increases in productivity. Its revenues increased by 21 percent in 2001, and it has remained a market leader.

By definition, implicit contracts are not enforceable by third parties. So what keeps the firm from simply claiming that the employee’s information-sharing efforts were poor and from pocketing the funds earmarked for bonuses or raises? A firm that reneges on its current promises may find that its employees expect it to renege on future promises. If so, employees may be unwilling to exert extra effort in the future. Thus, a firm that reneges on its promises will profit in the short term, but its damaged reputation will cost it in the longer term. A firm using implicit contracts must reassure employees that it will act in accordance with those contracts. The firm should verify that performance standards are applied consistently and should communicate clearly with employees in the event that economic conditions preclude the payment of promised bonuses or raises.

Subjective Performance Evaluation

Firms implement subjective performance evaluation in a variety of ways. Some perform 360-degree peer reviews, in which an employee’s supervisor, coworkers, and subordinates are all asked to provide information regarding that employee’s performance. Others use management by objective systems whereby an employee and a supervisor work together to construct a set of goals for the employee. At the end of some specified period, the two meet to review the employee’s performance on those goals.

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The supervisor will consider whether the goals were reached but can also take into account other factors that may have made them unexpectedly easy or difficult to attain. Still other firms implement merit rating systems, in which employees are given numerical scores. Often these systems give supervisors a fixed pool of points to be allocated among employees. In all these systems, subjective opinions complement or replace objective performance measures.

There are three costs to incorporating subjective performance assessments. First, supervisors may find it personally unpleasant to reward some employees but not others and may give all their subordinates an average (or even above-average) grade. This effect, known as ratings compression, weakens incentives. Some firms use forced rankings systems, in which evaluators are required to grade employees on a curve. Sun Microsystems, for example, requires supervisors to rate 20 percent of employees as superior, 70 percent as Sun standard, and 10 percent as underperforming.24 Firms using forced rankings must be careful to apply evaluation criteria fairly. Since 1999, Microsoft, Ford Motor Company, and Conoco, among others, have been sued by employees who have alleged that poor evaluations reflect supervisors’ biases rather than their own performance.

Second, subjective assessments of performance are subject to influence activity, which we described in Chapter 3. Subordinates may attempt to affect their evaluations by establishing good personal relationships with supervisors, perhaps spending too much time developing them. Chris Congdon, a computer support specialist at Ford, says that he was able to increase his ranking by regularly e-mailing computing-related news articles to all members of his department. This, he claims, increased his visibility to supervisors, even though the articles were of little value to computer users.25 Employees may also excessively promote their own pet projects while lobbying against, or even worse, hiding information from other employees who have their own projects.

Finally, subjective measures may be noisy, just as objective measures are. This introduces unwanted variation in compensation, with the requisite costly risk premium. As with objective measures, implementation of subjective measures requires a deft balancing of benefits and costs.

Promotion Tournaments

Subjective evaluations are often crucial to promotion decisions. Firms usually do not state promotion criteria as part of an explicit contract. Instead, there is a general understanding between the firm and its employees as to what sorts of actions will lead to promotion. As Edward Lazear and Sherwin Rosen have pointed out, promotionbased incentives often take the form of a promotion tournament.26 A set of employees competes to win a promotion, and the “prize” is usually a substantial increase in compensation.

Consider the case of a bank that employs two senior loan officers, one of whom will be promoted to vice president. If the duties of a vice president are somewhat similar to those of a senior loan officer, it may be sensible for the bank to promote the loan officer who turns in the best performance in that job. Suppose that the salary paid to senior loan officers is w. As part of the promotion, the winning loan officer receives a raise that increases salary to w*. The losing loan officer remains with the firm as a loan officer but receives no raise. Hence, the prize that accompanies the promotion is the wage differential w* 2 w. Each loan officer can increase the likelihood of promotion by increasing effort. The marginal benefit of effort is

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the increased probability of winning the promotion multiplied by the reward w* 2 w. Each loan officer will equate this to the marginal cost.27

The firm can encourage the loan officers to work harder by increasing the size of the prize w*. It should simultaneously reduce w. To see why it should adjust both, note that a potential employee will consider both w and w* when choosing where to work. Increasing w* gives the senior loan officers more incentive to work hard. It also makes the senior loan officer’s job more attractive (since the promotion prospects attached to this job are more attractive) and means that the firm can reduce w somewhat and still hire senior loan officers.

If there are more than two loan officers competing for promotion, the bank can maintain the same incentives for effort simply by increasing the size of the prize. To illustrate this point, consider the effect of adding a third senior loan officer to the tournament. This presumably reduces the likelihood that the first officer will win, as the officer must outperform both loan officer 2 and loan officer 3 to earn the promotion. The firm can offset this reduction in officer 1’s marginal benefit of effort by increasing w* or reducing w, thus making winning more valuable.

If there are successive rounds of promotion tournaments, the wage differentials between levels must increase in order to maintain the same incentives for effort.28 Consider adding another round to the bank promotion tournament. Suppose that a senior loan officer promoted to vice president eventually participates in another tournament that may result in promotion to chief executive officer. A senior loan officer who is not promoted to vice president cannot subsequently become CEO. Accordingly, part of the prize associated with being promoted to vice president is the right to compete for the CEO position. Senior loan officers therefore anticipate two potential prizes (promotion to VP and eventually to CEO), and this may motivate them to work extra hard. If the firm wants to motivate the same extra-effort level from vice presidents (who have only to look forward to becoming CEO), the CEO/vice president wage differential must be larger than the vice president/senior loan officer wage differential.

In deciding whether to use tournaments to provide incentives, a firm must consider the extent to which these factors apply to its specific situation. Advantages of using tournaments for incentives include the following:

•Tournaments circumvent the problem of supervisors who are unwilling to make sharp distinctions among employees. A promotion is an indivisible reward, the difference between the payoffs received by top and bottom performers is necessarily large, and incentives to be a top performer are strong. These factors necessarily counteract compression in subjective evaluations.

•Tournaments are a form of relative performance evaluation. Because only the relative ranking of competitors affects who gets the prize, any common random factors that affect performance are netted out.

Potential disadvantages of tournaments include the following:

•The individual who is best at performing a lower-level job may not be the right choice for a higher-level job. This may be especially likely if the lowerand higherlevel jobs require markedly different skill sets.

•Relative performance evaluation rewards employees for taking actions that hamper the performance of other employees. Hence, firms need to consider whether such actions can be monitored and discouraged before implementing tournament-based incentives.