Margaret H. Christ, Karen L. Sedatole, Kristy L. Towry, and Margaret B. Shackell
Sticks and Carrots: The Effect of Contract Frame on Effort in Incomplete Contracts
The Accounting Review | Volume 87, Issue 6 (Nov 2012), 1913–1938
(Original article authors were Christ, Sedatole, and Towry)
The economic downturn has caused managers to look more carefully at how to motivate workers. Does punishment work?

In our study, we examine employee effort under bonus vs. penalty contracts in an incomplete contract setting, in which the employee's pay is not deterministically based on objective performance measures. Incentive bonus contracts are one of many types of formal controls organizations implement to motivate and direct employee behavior. In prior research, we have seen evidence that negatively-framed controls can be perceived by employees as intrusive and as reducing their autonomy (Christ et al. 2008). People do not like to be controlled. They do not like to have their actions questioned or their decision rights limited. When negatively-framed controls are in place, employees can feel that their integrity and competence are questioned. This can lead to a feeling that the manager does not trust the employee and hence, the employee does not trust the manager. In the current study, we predict that incentive contracts that include penalties for low performance will be perceived negatively by employees and will evoke the same negative feelings that other negatively-framed controls are known to elicit. Therefore, our hypothesis is that employees working under bonus contracts will feel more trusted by their managers and will reciprocate that trust. Ultimately, we expect that this greater trust will cause employees working under bonus contracts to increase their effort, even on those tasks not explicitly governed by the contract.

The contract frame laboratory experiment

To test our predictions, we ran an experiment at a highly ranked U.S. business school with undergraduates: 52% female and 48% male, 20.4 years old on average. Each participant was assigned the role of either a manager or an employee and engaged in a two stage experiment. In stage one, employees were required to make a series of investment decisions on behalf of their managers. In one condition, managers could impose a contract that paid the employee a bonus if their investment selection achieved a target payoff. In another condition, managers could impose a similar contract that penalized employees who did not reach that target payoff amount. In all conditions, managers could pay employees a flat wage instead of the incentive contract. In stage two, employees could make another investment on behalf of their managers, but in this stage there was no incentive contract. Instead, managers could pay employees any amount of the returns earned by the chosen investment. Importantly, the second stage investment decision depends on the employee's trust in his/her manager. In particular, the employee decides the amount of his/her own money to invest on behalf of the manager. This investment is guaranteed to return three times the original investment, all of which is paid to the manager. To make an investment, the employee must trust that the manager will pay him/her at least as much as that initial investment amount. The more of his/her own funds the employee is willing to invest, the greater his/her trust in the manager.

Employee participants also answered a series of questions about their trust in their manager partners, the extent to which they felt that the contract was intrusive or limited their autonomy, and the extent to which they interpreted the contract as questioning their competence or integrity. We used participants' answers to these questions to understand the underlying motivation driving their behavior.

Our results are shown in Figure 1. The green arrows are the paths that are significant as predicted, and the red paths are not significant.

1: Test of full model: Comparison of penalty and bonus contract conditions
figcsts1

 

Participants facing the penalty contract reported feeling more intrusion and less autonomy than those facing the bonus contract. That intrusion felt like a signal questioning their competence and integrity, but the threat to their autonomy was not interpreted as such a signal. When participants felt that their integrity was questioned, they perceived less trust from their managers. As predicted, when employees perceived trust (mistrust) from their managers, trust (mistrust) was reciprocated, and when trust (mistrust) was reciprocated, the participants worked harder (less hard) on a task that was not governed by the initial contract. We also found a direct relation between contract frame (bonus contract vs. penalty contract) and perceived trust: those who received the bonus contract felt more trust than those who faced the penalty.

As previously mentioned, the managers in the experiment had the choice of whether to implement an incentive contract or not. In Figure 2, we compare the impact on trust of the choice to implement or not implement the bonus or penalty condition relative to the level of trust for employees in a fixed wage setting.

There are few observations in which the manager chooses NOT to implement the incentive contract, so we won't dwell on the downward sloping line. But as Figure 2 shows, the great difference in trust occurs when the manager chooses to implement a bonus contract versus a penalty contract.

In summary, our experimental results show that employees' trust in the manager matters, and that both trust and effort are lower when employees work under a penalty contract than when they work under a bonus contract. Therefore, both the frame of an incentive bonus contract, as well as the degree of contract completeness, are important determinants of effort.

2: Employee's perceived trust under the bonus and penalty contract conditions versus the fixed wage (baseline) condition
figcsts2

 

 

From the lab to practice

What can we learn from this laboratory experiment that will help firms in practice? Two things: First, trust is critical to the success of bonus plans, in particular bonus plans that include some level of supervising manager discretion. When employees feel intruded upon or that they lack autonomy, this begins a domino effect, with the final result being decreased effort. Such effects might be particularly acute in settings involving knowledge workers involved in creative activities where a sense of autonomy is paramount. A loss of trust induced by an incentive contract could be devastating. Incentive contracts intended to increase effort but perceived by employees to have a punitive element may backfire with dire consequences.

Second, incentive contracts with a penalty frame are tempting, especially given the current economic climate and the prior evidence that they are more effective than bonuses at eliciting effort. While penalty contracts of the form used in our experiment have not, and may never be, common in practice, the use of various other forms of punitive contracts is on the rise. Indeed, there are political efforts (e.g., 2010 Dodd-Frank Wall Street Reform Act) currently underway to require the use of “clawback provisions” at the executive levels as a means of recovering previously awarded incentive pay awarded based on financial performance later revealed to be erroneous. To the extent that such provisions are at the discretion of corporate boards, they will likely have some of the trust eroding effects that we document in the lab. There is also increasing use of “bonus banks” allowing for some portion of an earned bonus to remain “at risk” to fund negative bonuses in future years (Murphy (Sage 2012)). Such practices are at risk of having a negative impact on the trust environment, leading to unintended negative performance effects. How these forces will play out remains to be seen.


10-haridas
Unknown artist: Disguised Akbar with Tansen Visit Swami Haridas. India, 18th Century.. In this miniature painting (25×31cm), Emperor Akbar is disguised as a commoner, standing behind his legendary court singer Tansen during a visit to a Swami (a guru—sort of like Gene Fama). Notice how the green leaves in the background are intricately and carefully painted in different styles and different shades of green, an art honed by hundreds of hours of practice. Notice also the humility captured in the body pastures of all three figures. This painting hangs in the National Museum in New Delhi, which holds an exquisite collection of miniature paintings from different schools.

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