8. In order for a pay-for-performance system to have any positive impact on employee
performance, what conditions must be met? Explain each citing relevant
psychological
and/or economic wage theories. Also, based on your readings, what are some of the
potential
negative consequences associated with pay-for-performance schemes? Explain. (four
should
suffice --- include more if you really want to impress).
What conditions must be met?
According to Thompson and Strickland, management’s most powerful tool is reward
structure. Employee compensation is an important part of most organizational reward
systems. (Drost Lecture) In order to fully understand why pay-for-performance is given
such a high priority within some organizations, it is important to know what conditions
must be met and the theories behind merit pay.
The following four conditions must be met in order for a pay-for-performance system to
have a positive impact on an employee’s performance:
1. Employees need to be able to see a clear link between performance and
outcomes
2. Employees must have control over their performance and be able to achieve
obtainable goals
3. Rewards must have value and be meaningful
4. Positive outcomes must outweigh negative outcomes
Both the psychological and economic theories provide support for merit pay and suggest
that linking pay-for-performance should lead to improved performance because
motivation is increased, which ultimately helps organizations maximize profits.
Psychological Theories
 Expectancy theory – refers to the individual’s perception that a certain level of
effort is required to achieve a certain level of performance. The decision to act
depends upon three sets of perceptions, expectancy (effort), instrumentality
(performance), and valence.
The three building block of expectancy theory
1.Effort to performance [ E- P]
2.Performance to Outcome [P-O] (Instrumentality)
3.Valence [V] (attractiveness of the rewards)

Reinforcement theory – suggest that any behavior including performance is
determined by its consequences.
o Increased performance because monetary consequences of good
performance are made known to the employee
o Performance must be clearly defined
o Merit increases must be made contingent upon desired performance
o Size of increase should increase with levels of performance
o Pay increases should be given close in time to the desired performance

Equity theory – motivation not only depends on the pay and performance
relationship but it also depends on how a person compares him/herself to another
employee.
Equity Comparisons
Outcome to self
versus
Outcomes to others
Inputs by self
Inputs by others
If an employee perceives that the ratio of his or her outcomes to inputs is less than the
ratio of outcomes to inputs of others then the employee may feel under rewarded.

Goal-setting theory –increases motivation as a result of setting goals if they are
specific, challenging and accepted by employees. Goal-setting theory suggest the
following:
o Merit increases should be contingent on specific rather than “do your best”
goals
o Increases should be based on goal difficulty as well as goal
accomplishment
o Goals and increases should be discussed at the same time
Economic Wage Theories
The economic wage theories look at the employer’s perspective (cost) rather than the
employee’s perspective (attractiveness of outcomes)



Marginal Productivity theory – pay is issued on the basis of performance to
minimize labor costs and remain competitive in the labor market. According to
reading this system serves as:
o An incentive to employees to expend greater effort
o Attract employees willing and able to work hard
o Diminish the chances of the best performers leaving the organization
while the worst performers remain
Implicit Contract theory – “A fair day’s pay for a fair day’s work” this captures
the contract between employer and employee.
o Performance must be measured not assumed
o Performance ratings should be adjusted for factors outside an employee’s
control
Efficiency Wage theory – effort is determined by the level of wages for example a
premium wage is paid to ensure that employees perform up to their maximum
levels.
o Merit pay levels should be aligned with competitive market
o Increases are particular important in low-wage organizations
o Merit pay should lead to better self-monitoring performance
The theories can be summarized using parts of expectancy theory. Both efficiency wage
theory and goal-setting theory address the perception of the relationship between effort
and performance. Efficiency wage theory suggests that if you provide merit pay
employees will feel obligated to put effort forward and not reduce their duties. Goalsetting theory suggests that merit pay may lead to increased effort because it may induce
the setting of and commitment to more difficult goals.
Negative Consequences
1. Decreased Intrinsic Motivation – by rewarding people for what they already
enjoy doing will decrease motivation.
2. Decreased Cooperation – individual rewards foster conflict rather than
cooperation as work group members compete against one another for pay.
3. Decreased self-esteem – if an employee’s perception of his/her performance
is high and a merit increase is low they may feel disappointed.
4. Decreased equity – can be identified in the Matthew Effect and the over
rewarded inequity.
5. Matthew effect – merit increases are frequent and plentiful for good
performers. Where as average to poor performers suffer because money is
taken away from them to provide larger merit increases to good performers.
This leads the lower performers to perceive inequity as their pay is reduced
to reward better performers.
6. Overreward inequity – high performers receive disproportionately higher
merit increases compared to low performers.