Risk aversion and effort under an incentive pay scheme with multiplicative noise. Theory and experimental evidence

Pages130-144
Publication Date03 Aug 2015
DOIhttps://doi.org/10.1108/EBHRM-01-2014-0003
AuthorNikolay Zubanov
SubjectHR & organizational behaviour,Global HRM
Risk aversion and effort under
an incentive pay scheme with
multiplicative noise
Theory and experimental evidence
Nikolay Zubanov
Faculty of Economics and Business Administration, Goethe University
Frankfurt, Frankfurt am Main, Germany
Abstract
Purpose The purpose of this paper is to consider the influence of individual risk preferences on the
effectiveness of incentive pay schemes, by examining the link between individual effort and risk
aversion in situations where outcome uncertainty multiplies with effort. Such multiplicative noise
situations are common, occurring whenever payment is awarded per success rather than per attempt.
Design/methodology/approach The paper developsa theoretical model which predicts a negative
risk aversion-effort link under multiplicative noise without a performance target (PT), and a weaker
negative link once the target is introduced. This model is then taken to the data from a labexperiment
where participantswere randomly assignedto a control group, which receivedfixed pay, and a treatment
group, which received a piece rate awarded with a certain probability, with and without a PT.
Risk aversion is measured with a menu of lottery choices offered at the end of the experiment.
Findings Compared to their peers in the control group, the more risk-averse participants in the
treatment group put in progressively less effort in the absence of a PT. The introduction of a PT
substantially weakens this negative risk aversion-effort link, so that there are no more significant
differences in performance between the more and the less risk averse.
Research limitations/implications The papers findings speak to the empirical puzzles of
incentive pay schemes backfiring and of the proliferation of PTs. The negative risk aversion-effort link
may be one reason behind the failure of incentive schemes to deliver improved performance, whereas
the weakening of this link may be one justification for the existence of PTs.
Practical implications In the multiplicative noise environments, managers should take their
workersrisk preferences into account when designing incentive pay schemes. A PT may be a useful
motivational tool for the risk-averse workers who are more likely to under-perform.
Originality/value The multiplicative noise environment has been largely overlooked by the
existing literature, yet it is common in practice. An example is the work of a sales agent who receives a
bonus per sales which succeeds with a certain probability after each customer contact. This paper is
one of the first to model, and test experimentally, worker performance in this environment.
Keywords Employee motivation, Work performance and productivity,
Promotion and compensation, Labour economics
Paper type Research paper
1. Introduction
Consider a sales agent who earns a commission per deal which succeeds with a certain
probability after each customer contact. The more contacts he or she makes, the hig her
are the expected earnings, but so too is the earnings risk. What is the relationship
Evidence-based HRM: a Global
Forum for Empirical Scholarship
Vol. 3 No. 2, 2015
pp. 130-144
©Emerald Group Publishing Limited
2049-3983
DOI 10.1108/EBHRM-01-2014-0003
Received 28 January 2014
Revised 7 April 2014
Accepted 23 April 2014
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2049-3983.htm
The author thanks seminar participants at Goethe University Frankfurt, Erasmus University
Rotterdam, Tilburg University and St. Petersburg University, and in particular Vladimir
Karamychev, Floris Zoutman, Casper de Vries, Canice Prendergast and Bram Cadsby, for their
helpful comments. Excellent assistance of Sabine van Boxtel, Marijn Matthijsse and Alvaro
Serrano Macon in preparing the experiment featured in this study is gratefully acknowledged.
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EBHRM
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