Principal-Agent models of the Employment Relationship and
Performance-Related Pay
by P. A. Lewis
Introduction
1
Performance-Related Pay as a Solution to Adverse Selection & Moral Hazard
2
The Costs of Performance-Related Pay and the Optimal Intensity of Incentives 5
Absolute Vs. Relative Performance Pay
7
Limitations of the Theory
9
Conclusion: Performance Pay and the Modernisation of the Public Sector
14
Lewis, P.A. (forthcoming). ‘Principal-Agent models of the Employment
Relationship and Performance-Related Pay.’ In N.F.B. Allington and J.S.L.
McCombie (eds.), The Cambridge Student Handbook in Economics. Cambridge:
Cambridge University Press.
Introduction
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Examines how private-sector agents have tried to develop solutions to
some of the problems created by asymmetries of information between
employers and their (actual or potential) employees
o Asymmetries: employers’ inability to observe characteristics
and/or actions of workers
Examines merits and limitations of performance-related pay
DEFINITION: “performance-related pay can be defined as any linkage
between an employee’s earnings and any measure of his or her
performance on the job” (p.1)
o E.g. tying pay to output, such as piece rates for manufacturing
workers; bonuses that reward footballers for scoring goals;
commissions; and pay and profit linking, such profit-related
bonuses or share-options
DEFINITION: “A principal-agent relationship is a situation in which one
person (the ‘agent’) is called upon to act on behalf of another (the
‘principal’) and advance the latter’s goals.” (p. 1)
o DEFINITION: “The principal-agent problem: the general problem
of designing contracts which ensure that the principal’s goals are
pursued as efficiently as possible.” (p. 1)
2 types of problems in principal-agent relationships that prevent effective
contracts
1. Adverse selection: pre-contractual opportunism; hidden
information that affects the net benefit to the principal e.g. workers
know more about their ability than employers  low ability
workers will portray themselves to be higher ability to get a better
job
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2. Moral hazard: post-contractual opportunism; hidden action that
affects the principals when agents pursue their own self-interest
and deviate from the principal’s preferred course of action e.g.
workers might prefer to shirk their duties than work as hard as the
employers wish
 2 conditions for adverse selection and moral hazard to
occur:
1. Asymmetries of information between principal
and agent e.g. workers know their own ability
and level of effort but there is no way the
employer can prove to a court that workers have
failed to fulfil their contractual obligations
 IF information was symmetrically distributed
and employers could observe and verify (to a
court of law) workers’ attributes and actions
then employment contract would specify
precise attributes workers are required to
have, actions they’re meant to take and the
wage given in return therefore an
enforceable contract
2. Divergence of interest between principal and
agent e.g. employers want to hire hard-working
people but the workers have incentive to exploit
their private knowledge of their abilities by
exaggerating or shirking their duties and putting
less effort than their employer wishes
 IF interests were aligned, the agent would
automatically do what the principal wanted
because it would be in their interest to do so
Principal-agent problem of the principal (employer) hiring a worker
(agent) who is meant to work on behalf of the principal to work as
efficiently and effectively as possible
o PRP meant to create an employment contract that will: 1) attract
workers and 2) motivate employees to pursue employer’s goals in
a diligent fashion
Performance-Related Pay as a Solution to Adverse Selection & Moral
Hazard
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Principal-agent theory assumes employers can observe some (imperfect)
measures/indicators of worker talent and conscientiousness
o E.g. employers can observe level of output/ sales made by workers
and profits generated (positively correlated with worker ability
and effort)
Measures are imperfect and inaccurate because above indicators of
performance are affected by other factors
o E.g. worker output can be affected by equipment breakdowns and
profit is affected by managerial talent and effort, competitors’
actions, variations in input availability and price, changes in
governmental legislation and consumer tastes
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Despite variations in indicators they are reasonably correlated with
worker effort and ability and provide some information about talents and
actions of workforce
o Act as observable proxies for unobservables like effort and ability
Pay schemes that link workers’ earnings to performance enables the
employer to link the interests of employers and workers
A well-designed performance-related pay scheme will sufficiently
compensate the worker for the disutility of extra effort they put in to
work harder/produce more
o E.g. compensation schemes that link CEO’s pay to firm profits can
be used to align shareholders interests and CEO’s interests
Rationale for performance-related pay schemes is that they promote goal
congruence, where an appropriately designed scheme changes workers’
interests so that the rational thing for a utility-maximising worker to do is
to behave in the way desired by their employer
Edward Lazear’s (1999) diagrams illustrate how PRP can overcome
adverse selection and moral hazard
o Horizontal axis: effort exerted and level of output produced by
worker
o Vertical axis: level of pay received
o Employers assumed to be risk-neutral; workers assumed to be risk
averse
Diagram (a): The initial situation (fixed wage)
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Fixed wage = w; employees paid (w) just by turning up to work and
exerting bare minimum of effort (e0)
Workers’ budget constraints start at the origin (O), moves along
horizontal axis to eo, rises vertically to A and stretches right horizontally
Workers dislike higher effort but want higher pay, making the direction
of all workers’ increasing preference to the northwest corner of the
diagram
2 kinds of worker
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o High ability represented by ICH1; relatively flat indifference curve
which represents the fact that they need relatively small increase
in income to compensate for extra effort
o Low ability represented by ICL2; relatively steep indifference curve
to represent the fact that putting in extra effort costs the lowability workers a lot of disutility and must be compensated with
large increases in income
Where a fixed wage is offered, both utility-maximising workers will
choose point A, using the bare minimum of effort (eo)
o Point A is the furthest northwest point that both types of workers
can reach
Diagram (b): The impact of performance-related pay (piece-rates)
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Guarantees minimum wage (W) for every worker but additionally,
workers can earn a bonus of £b for every unit of output produced over
level of output q*
o Compensation = max [W, bq – K]
 K = constant term included to ensure that the agent’s
individual rationality constraint (of which more later) is
satisfied
Budget line starts at the origin (O) and moves along horizontally to eo,
vertically to point A, stretches horizontally to the right as far as the level
of output q* and then rises (blue line) to the northeast as bonus payments
are introduced
Low-ability workers’ behaviour remains unchanged because even after
the change in budget constraint through the bonus payment scheme, the
point furthest northwest that a low-ability worker can reach stays point A
on ICL
o Disutility of the effort required to produce more output exceeds
the utility gained from extra bonus payments
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Change in budget implies high ability workers can reach a higher
indifference curve (red curve) because bonus payments compensates
them for the disutility of extra effort of producing above q*
New equilibrium for high-ability workers is point B where their
indifference curve ICH2 is tangential to the upward-sloping portion of the
new budget line
Effort has increased from eo to eH2 and pay has increased from W to WH2
with utility increasing from UH1 (on old indifference curve) to UH2 (new
indifference curve)
This particular pay scheme can be considered incentive compatible
because the bonus payments are sufficient to ensure that it is in the
interest of high-ability workers to increase their level of effort (Lazear
1999: 212-15)
PRP can help overcome moral hazard by inducing a higher level of effort
from workers; high-ability workers would want to put more effort in
rather than in a fixed-wage scheme
PRP can also overcome adverse selection; bonus payments can lead to the
increase of utility of high ability workers from UH1 to UH2
o Some high-ability workers would be more willing to accept a job
with this firm than if they used a fixed-wage scheme because they
can receive a higher level of utility than UH1 at any other firm
o Attracts more high-ability workers as they are being paid more
(wage WH2) at this firm
In other words, workers whose reservation utility lies between UH1 to UH2
(that is, workers whose reservation wage lies between W and WH2), and
who were therefore initially unwilling to join the firm, now find it in their
interests to join this firm’s workforce – their participation constraint is
now satisfied - raising the average quality of the firm’s workforce and
thereby helping to overcome the adverse selection problem (Lazear 1999:
214-15; Prendergast 1999: 14-15)
The Costs of Performance-Related Pay and the Optimal Intensity of
Incentives
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Performance-related pay schemes leads to an inefficient distribution of
risk compared to the first-best, full information outcome
o Employers must pay workers a higher expected wage under PRP
schemes than under a fixed-wage system to compensate for the
extra risk employees must bear
Where employers assumed to be risk-neutral and workers assumed to be
risk-averse, optimal distribution of risk would involve the risk-neutral
firms bearing all the risk by giving the risk-averse workers a fixed wage
and bearing no risk to themselves
o However, if a worker’s wage is fixed they have no incentive to
perform better than they need to because it’s not attached to their
performance
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o But under PRP schemes, because performance measures are
affected by external factors that lie outside the control of workers,
they are exposed to higher risk variations in their income
 Workers must bear some of the risk, leading to inefficient
distribution of risk compared to first-best, full information
outcome
When effort is not observable, there is a conflict between the goal of
providing incentives and the goal of ensuring an efficient distribution of
risk
o The only way that it is possible to provide the worker with the
incentive to work hard is by relating his pay to actual output, the
level of which is affected by random factors that lie outside of his
or her control
Because PRP schemes can expose risk-averse workers to risk, it has
important consequences
o The risk that PRP exposes risk-averse workers to will reduce their
utility
When a worker is risk averse he or she prefers a wage of £x for certain
compared to a risky wage that has an expected value of £x
o Risk-averse workers are worse off with a risky wage than if they
would be receiving £x for certain
To ensure the workers’ participation constraint is satisfied, employers
wishing to adopt PRP schemes must pay workers a higher expected wage
under the PRP scheme (which is riskier) than under the fixed-wage
system (riskless) (Prendergast 1999: 8; Mas-Colell, Whinston and Green
1995: 486)
o Higher expected wage is the cost to the employer for using PRP
schemes
o Employer hopes to recover the cost through higher profits
expected through workers working harder/producing more/being
more motivated
o A profit maximising employer will use PRP to extract extra effort
to the point where marginal increase in expected revenue from
higher output equals the marginal cost of higher expected wages to
compensate for risk-averse workers’ disutility of exerting more
effort (Gibbons 1997: 3; Burgess and Ratto 2003: 286)
If we are thinking about situations in which effort is a continuous variable
that can take any one of many values, then the level of effort which it is
optimal for a profit-maximising employer to induce obtains when the
marginal increase in expected revenue due to the extra output yielded by
a slightly higher level of effort is just equal to the marginal cost of the
higher expected wages required to induce that effort (pg. 12)
The term ‘intensity of incentives’ denotes the rate at which at which a
worker’s pay increases with the level of output he or she produces (pg.
12)
o i.e. the higher the value of b in the expression for the worker’s
compensation (graph) and the more the more the worker’s pay
goes up as his or her output increases
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The optimal intensity of incentives b* occurs when the marginal benefit to
the firm of making the worker’s incentives a bit more intense (i.e. the
extra profits that the firm expects to earn if the worker puts in a bit more
effort) equals the marginal cost of the increased intensity of incentives
(i.e. the expected increase in the worker’s wages after the implementation
of performance-related pay) (pg. 12)
The following factors influence the optimal intensity of incentives
(Milgrom and John Roberts 1992: 221-26; Gibbons 1997: 4):
1. Profitability of extra effort: the optimal intensity of incentives b* is
greater when the contribution of the worker’s extra effort is
expected to increase employer’s profits
o The more that extra effort is expected to add to the
employer’s profits, the employer is willing to incur greater
costs to obtain that effort thus the greater is the optimal
intensity of incentives, ceteris paribus
2. Agent risk aversion: the optimal intensity of incentives b* is lower
when the agent is more risk averse
o The agent suffers higher disutility when their income is
unpredictable due to the variations from performancerelated measures and it is more costly to compensate the
worker to bear the above risks; thus the more costly it is to
generate incentives, the lower the optimal intensity of
incentives is, ceteris paribus
3. The accuracy with which the worker’s effort can be estimated: the
optimal intensity of incentives b* is lower when the variance of the
estimate of worker effort is higher
o The less precise a worker’s effort can be measured, the
optimal intensity of incentives is lower; inaccurate, noisy,
high-variance estimates of worker effort impose higher
risks to workers and consequently increases the cost of
compensating the workers for bearing the extra risk
(relates to point 2)
4. The rate of change of the marginal cost or disutility of effort to the
worker: the optimal intensity of incentives b* is lower when the
faster the disutility of effort increases as the worker’s overall level
of effort increases
o As the disutility of effort increases when the worker’s
overall effort level rises, employers must increase the
expected wage (and therefore the cost) offered by the
employer to compensate the worker for the higher level of
effort/disutility; the faster the expected wage must grow,
the lower the optimal intensity of incentives is ceteris
paribus
Absolute Vs. Relative Performance Pay
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Workers’ risk-averse nature and that they must be compensated with
higher expected wages implies that profit-maximising firms will try to
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minimise the costs of implementing PRP to generate the particular
intensity of incentives
o Use performance indicators that measure effort as accurately as
possible
Informativeness principle states the following: in designing their
compensation formulas, employers should make their workers’ pay
depend on any performance indicator that (with appropriate weighting)
reduces the overall error with which the employee’s level of effort is
estimated
o The employer will be able to minimise the costs of offering his or
her workers incentives of a given intensity (Holmstrom 1979;
Milgrom and Roberts 1992: 214-21; Prendergast 1999: 12-14).
Consider the equation w =  + (q + y) which describes a linear
compensation scheme that makes a worker’s pay (w) dependent not just
on his or her level of output (q) but also upon a second measure of
performance (denoted by the letter ‘y’)
o The Greek letter phi () in this expression is a parameter which
denotes the weight accorded to the second performance measure
‘y’ in the formula by which workers’ pay is determined
o If  is set equal to zero, then the second performance indicator
carries no weight and the performance-related component of
worker pay is determined solely by the first measure of
performance (q) or if it is not set to zero, the second performance
measure plays a role in the worker’s pay
 What weight (if any) should be accorded to the second
performance indicator (i.e. what should the value of  be)?
(Use informativeness principle)
Informativeness principle suggests that the value of the weighting factor 
should be set to minimise the variance of the estimate of worker effort
o Doing so will minimise the risks that workers are exposed to, given
that it is necessary to give them incentives to work hard, and will
therefore minimise the costs of the extra pay that the employer
must offer the workers in order to compensate them for bearing
risk
It can be shown that the weight * which it is optimal to attach to the
cov( , y)
second measure of performance is given by the equation * = var(y)
o cov(θ, y), the covariance of θ and y, is a statistical measure of how
θ and y vary together (Milgrom and Roberts 1992: 246)
The relation between the second performance indicator (y) and the
random factor () which, along with effort, influences a worker’s output
If cov(θ, y)  0, so that there is a non-zero correlation between the
random variable θ and the second performance indicator y, then a
knowledge of y does provide the employer with information about the
value of the random variable θ
If * is negative then, according to equation (2), high positive values of the
second performance indicator (y) will tend to reduce the worker’s pay,
while negative values of y will tend to increase the worker’s pay
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Should employers use absolute or relative (in comparison either to each
other or to workers in other firms) measures of performance?
o Example: worker is a manager
 Absolute measure: the level of his own firm’s profits viewed
in isolation
 Relative measure: firm’s level of profits relative to the
average level of profits across the industry as a whole
2 possible cases: 1) when the random shocks which impinge upon this
industry are pretty much the same across all firms 2) where different
firms are affected by different shocks, so that few if any of the random
disturbances are common to all firms
1. If most of the random shocks are common to all firms in the
industry, then those shocks may well significantly affect the
absolute levels of performance of all firms, so that the absolute
measure of performance is likely to provide a relatively inaccurate,
high-variance estimate of worker effort
o But if all firms are facing the same shocks, the random
effects won’t have much impact on firms’ performance
relative to one another
o In this first case, differences in the relative performance of
firms are likely to reflect differences in the levels of effort
put in by their managers
o In such circumstances, a relative measure of managerial
performance, such as how one firm’s profits compare to
the industry-wide average, will provide an accurate, lowvariance estimate of managerial effort
2. If firms are affected by different shocks, differences in relative
performance of firms can reflect differences in the random factors
that impinge upon them rather than variations in the levels of the
effort put in by the managers
o In this case, a relative measure of managerial performance
such as our second performance (y) will provide an
inaccurate, high-variance estimate of managerial effort
because it will incorporate, rather than filter out, the noise
from random effects
o In situations like this, where the relative measure of
performance (y) has a high variance, the weight attached to
it in the optimal compensation scheme will be low and pay
will depend more on the absolute measure of performance
(Prendergast 1999: 14).
Limitations of the Theory
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Explicit performance-related pay schemes are far rarer than principalagent theory would at first glance suggest
The schemes which do exist seldom account for a significant part of a
worker’s compensation
Jensen and Murphy (1990) studied the relation between pay and
performance in 1,300 US corporations between 1974 and 1986
o Empirical relation between pay and performance was
economically insignificant, with CEO wealth changing by just $3.25
for every $1,000 change in shareholder value
 Link between pay and performance weaker than principalagent theory predicts; provides very weak incentives for
managerial effort
 Evidence for the UK is provided by Cully et al. (1999), who found that
only one in ten non-managerial employees has individual PRP
 More enjoy the benefits of Share ownership (one in seven) and profitsharing (one in three), but they remain very much a minority
 Reasons why predictions of principal-agent theory concerning PRP are
flawed centre on the fact that the principal-agent models considered
make a number of rather unrealistic assumptions concerning: (i) the
nature of the jobs that workers perform; (ii) the information available to
employers; and (iii) the motivation of workers
i) Nature of the jobs workers perform
a) Multi-tasking
o Has been implicitly assumed that effort is a simple, onedimensional measure of how ‘hard’ a worker works
o But most jobs entail a variety of tasks, which include a
number of activities/dimensions where a worker can exert
effort
 E.g. workers on a production line can devote effort to
quantity and quality of their output; teachers are meant
to pursue numerous goals such as teaching, instilling
intellectual curiosity etc.
o Employers should ensure workers are allocating energy
appropriately between the different dimensions of their
jobs
o Problem of multi-tasking analysed by Holmstrom and
Milgrom (1991)
 E.g. There are 2 dimensions of a person’s job and both
are substitutes for each other, where the time and effort
devoted to each activity cannot be devoted to the other;
assumed that the employer cannot observe how
workers allocate their time
 Holmstrom and Milgrom argue that if an employer
bases workers’ pay conditional to the activity where
performance is measurable, a rational worker will put
all of his effort into that activity to ultimately maximise
his pay
o When pay is dependent on easily-observable performance
indicators, it can lead to the neglect of a desirable but less
easily observable goal
 E.g. workers on a production line whose pay focuses on
piece rates would be tempted to merely focus on the
quantity aspect of their jobs and neglect quality
 E.g. teachers are meant to pursue numerous goals;
while they aren’t mutually contradictory, given the
finite resources they compete for time and attention
and are not precisely measurable
 If teachers were paid solely according to the
examination results achieved by their pupils, they
would have an incentive to concentrate exclusively on
equipping their students with the narrowly defined
basic skills that are tested in standardised
examinations, and to neglect the other aspects of their
job just because doing so would be the most effective
way for them to maximise their pay
o The general point made by Holmstrom and Milgrom is that
where there are multiple tasks associated with a particular
job, incentive pay serves not just to allocate risks and to
motivate people to work hard; but also to determine how
workers allocate their time and effort among the various
duties associated with their job
o When there are multiple dimensions to a job,
inappropriately designed performance-related pay schemes
can lead to dysfunctional behavioural responses or
‘gaming’
 People substitute effort away from those aspects of
their job for which they are offered the least intense
incentives and towards those activities for which the
incentives are most intense
 Gaming, then, might be defined as consisting in
strategic responses to performance measures that
increase performance outcome but result in costly
misallocations of resources
o Equal-compensation principle: if a worker’s allocation of
time between two different activities cannot be monitored
by the employer, then either the worker must be offered the
same intensity of incentives for each of those activities, or
the activity from which the worker receives the lower
expected marginal rate of return for her efforts will be
completely neglected
 Illustrates the constraint on PRP that multi-tasking
imposes
o When a worker has 2 dimensions in their job, where the
first is less accurately measured than the other aspects of
the job
o If the employer wants the worker to put effort into both
dimensions of her job, she must reduce the incentives
offered for the second, more accurately measured activity
below what would be optimal if that activity were the only
aspect of the worker’s job until the incentives have the same
intensity for both jobs. Only then will a rational worker
devote time and effort to both activities
o
o
o
o
o
When performance cannot be measured at all in an activity
that the employer wants the worker to devote time and
effort into, they should not offer any incentive pay
If one dimension isn’t measurable, you cannot offer positive
incentives to those who work hard at it; if you offer positive
incentives to another aspect of their job where performance
is measurable, then you give the worker incentive to
allocate all their time and effort to that one dimension
Holmstrom and Milgrom (1991): inability to measure
workers’ performance in some aspects of their job can
undermine the case for PRP to obtain a high level of effort in
other dimensions of the job
Can explain why PRP is not used as much as principal-agent
theory predicts
Employers fear “gaming” and dysfunctional behaviour
responses when jobs have multiple activities
b) Team production
o Workers may have to contribute efforts into a joint product
which makes the output/contribution of the individual
harder to distinguish
o An individual will not have a well-defined marginal product
in team production
o Employers could use group incentives
 Making each individual’s pay dependent on the group’s
output would be beneficial because it can provide
incentives for individuals in the group to work hard
themselves and gives them the incentive to monitor one
another
 Team members are better placed than managers to
monitor each others’ efforts and would be able to deter
shirking by threatening those who do not pull their
weight (e.g. ostracising them)
o Size of group limits the usefulness of group incentive
schemes
 Free riding: in a group of “n” workers, where an
individual worker bears the disutility of an increase of
their effort, he or she only gains (1/n)th of the bonus
generated because the group bonus is shared by all “n”
members
 Where “n” is larger, the rewards received by an
individual for working harder are smaller compared to
the costs of extra effort, therefore causing free riding on
the effort of their team members’ effort
o Not always easy to find clear, viable and meaningful
targets/standards for teams especially when there is no
tangible output
ii) Information available
Informational problems that employers face associated with
PRP are more severe than principal-agent theory supposes
o Principal-agent theory is built on asymmetric information
where they assume that employers are unable to observe
the worker’s level of effort but they assume that employers
know quite a bit
 Assumes that there is an objective measure of output and
that employers know the distribution of effort for a given
level of worker effort, assuming that employers know
how output is related to worker effort
o
a. The absence of objective performance measure
o Not always the case that there is a verifiable, ‘objective’
measure of performance
o Use of share options/other equity-linked incentive schemes
has been the most commonly used way of aligning interests
of the company’s managers (agents) and shareholders
(principals)
 Making managers’ wealth depend on share price of the
firm is meant to motivate them to pursue the interests of
their shareholders by maximising profits instead of
pursuing company growth and engaging in other nonprofit-maximising activities
 However, this has also motivated managers to
manipulate the earnings of their companies to artificially
inflate measured profits and therefore share price to
increase the value of managers’ shares beyond the
company’s true performance e.g. Enron’s use of
accounting and financial manoeuvres to misrepresent its
true financial performance
o Examples are meant to cause doubt that performancerelated pay schemes involving share options are the right
way to motivate managers faithfully to pursue the interests
of their shareholders (Healy and Palepu 2003)
o Another example of performance manipulation is the case of
teachers where they cheated by providing students with
correct answers to public tests or altering their answers to
improve their scores (Propper and Wilson 2003: 252)
o Jacob and Levitt (2003) move beyond anecdotal evidence by
reporting the results a large-scale study of cheating by
teachers on tests in the Chicago state school system
 Between 4% and 5% of teachers cheat each year
 The incidence of cheating increases the more the
government attempts to reward teachers and schools on
the basis of pupils’ performance in tests, especially at the
lower end of the performance scale
b. Lack of knowledge of the conditional probability density
function that relates a worker’s output to his effort
o Principal-agent models also assume that the principal
knows the ‘conditional probability density function’ that
describes how output is (stochastically/randomly) related
to the level of effort exerted by the worker
o Various techniques used to determine how much output
workers can produce when they’re exerting a reasonable
level of effort, thereby allowing employers to set a standard
of where PRP should be placed
 However, these techniques may not elicit the relevant
information because it is in the workers’ interest to work
slowly when standards are being set to exaggerate the
difficulty of their jobs
 Workers hope that by doing so it will lead to lower
standards being set, enabling them to obtain large
bonuses when they actually start putting in a reasonable
amount of effort (Milgrom and Roberts, 1992: 232-36)
 E.g. study of the British metalworking industry in early
1970s which found that workers’ ability to thwart
attempts to use time and motion studies to uncover the
relationship between worker effort and output proved to
be so costly to employers that they eventually led to the
abandonment of performance-related pay in UK
metalworking (Brown 1973)
Conclusion: Performance Pay and the Modernisation of the Public
Sector
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Reform of the public sector in the UK has focused on the improvement of
incentives so the use of PRP to improve public sector efficiency is
becoming increasingly important
o New Labour’s program for modernising public services and
increasing accountability and demonstrating value for money
The nature of the work undertaken in the public sector and the character
of the workforce employed may render PRP highly problematic
o Difficulty of defining and measuring output
o Prevalence of multi-tasking
o Importance of teamwork
o Existence of norms of professional conduct and capacity to
providing workers with the intrinsic motivation to avoid shirking
and to work hard
Theory of incentive contracts suggests that the optimal compensation
scheme is one without PRP or at most gives rise to very low-intensity
incentives (Dixit 2002; Burgess and Ratto 2003)
Example: teaching
i) Teacher’s output is hard to observe and quantify (Propper and
Wilson 2003: 258-61; cf. Kessler 1994: 484-85; Back 2000: 250); if
output can only be measured vaguely (so that only high-variance
estimates of teacher’s efforts are available) then the optimal
payment scheme will contain performance based incentives with
weak to low-intensity
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ii) Teaching is a multi-divisional job so compensation based on easilyobservable and quantifiable outputs will distort incentives and
lead to dysfunctional behaviour (Dixit 2002: 718; Wiggins and
Tymms 2002; Propper and Wilson 2003: 259-60)
iii) Teaching involves a lot of teamwork and so contribution of any
one teacher may be hard to isolate; where teamwork is important,
the use of individual PRP can be counterproductive because it
might underline the incentives for individual teachers to cooperate
with one another. E.g. competition for individual merit awards can
lead to opportunistic and non-cooperative behaviour among
teachers (Marsden and French 1998; Adnet 2003)
iv) Teachers are professionals that might not be motivated by
economic considerations but also by commitment to the norms of
professional conduct; the use of PRP may be counterproductive if
the extrinsic, financial incentives erodes or crowds out the
intrinsic motivation generated by teachers’ commitment to their
profession
The main lesson to be learned is that the nature of the public services –
both of their output and also of the people who work in the public sector –
renders a naïve, blanket application of performance-related pay
extremely unwise
Dixit, 2002:
o Public-sector agencies have special features, most notably a lot of
dimensions/tasks that make it inappropriate to apply PRP and
could generate dysfunctional behaviour
o Traditional incentives have to be applied selectively to easilymeasureable, clear and defined performance indicators
o PRP should relate the probability of success to specific
characteristics of the agencies of organisations, and theoretical
research on the design of new reforms should likewise pay
attention to these specifics (Dixit 2002: 697)
Incentives should be tailored specifically to each different public sector
agency by looking at:
i) Significance of output measurement problems
ii) Multi-tasking
iii) Team-working
iv) Intrinsic motivation