The Advisors' Blog

I blogged a few years ago about a survey from Professors Alex Edmans, Tom Gosling, and Dirk Jenter that found CEOs are more motivated by a sense of “fairness” than by adding a few more zeros to their bank accounts. In a follow-up study that was just published in the American Economic Review: Insights, Professor Edmans teamed up with Pierre Chaigneau and Daniel Gottlieb to examine what type of “fairness” concerns are most motivating.

The pre-print version of the study is available here. In addition to including a lot of complex equations that reminded me why I became a lawyer and blogger instead of an economist, it offers these findings about pay-for-performance:

We showed that fairness concerns do not lead to the agent being paid fair wages for all output levels; in contrast, unfair wages can induce effort efficiently. The optimal contract involves two thresholds for output. The agent receives zero below the lower threshold, the entire output above the upper threshold, and the fair wage in between. When fairness concerns are sufficiently strong, the top region disappears, and the contract becomes performance-vesting equity. Most other contracting theories predict continuous contracts, or extreme discontinuities where the agent’s pay switches from zero to the entire output.

Even if the incentive constraint is slack, pay is increasing in output – paying the agent the fair wage over a range of outputs reduces perceived unfairness and satisfies the participation constraint efficiently. As a result, the firm can induce CEO effort “for free”, potentially rationalizing why incentives are given even to intrinsically motivated agents.

It makes sense that the threat of “no payout” is a big motivator. Money doesn’t buy happiness, especially when you’re already wealthy. So it sounds like companies are on to something by requiring “threshold” performance for a payout. It makes you wonder whether “moonshot awards” move the needle, but it’s probably difficult to generalize human motivations across the board…

– Liz Dunshee