Why Do Firms Use Incentives that Have No Incentive Effects?

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  • 1 January 2000
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      • Published in RePEc
Abstract
Firms often pay individuals for group-level, industry-level, or even economy-wide performance when agency theory suggests these contracts provide minimal incentive and lead to inefficient risk bearing. This paper derives a simple model of why firms might choose to implement stock options, profit sharing, and other pay instruments that reward (or penalize) "luck." The model relies on two key assumptions: 1) adjusting the terms of employment contracts is costly to the firm, and 2) agents' outside opportunities are not constant. I explore how firm-performance-based pay will respond to variation in risk aversion, workers' reservation utility, and the correlation between a firm's performance and that of the economy as a whole. I also discuss how the model fits with widely distributed stock options (especially in risky businesses such as high technology), executive compensation, and profit sharing. The model suggests that, while agency theory has focused on incentive compatibility, the often-overlooked participation constraint can help explain many common compensation schemes.
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