The Power of Incentives

Abstract

Variable pay is usually defined as pay that is tied to some measure of worker output. The most typical form of variable pay historically was the piece rate, which was more prevalent during the early part of the 20th century than it is at the beginning of the 21st. There is a resurgence in variable pay, particularly as it relates to executives, whose pay is tied to output through some mechanism like stock options or bonuses that depend on individual or firm performance. Why use variable pay? The typical reaction is that variable pay provides incentives to put forth effort. Although true, discrete-pay schemes also generate incentives. Much of the confusion in the literature results from the use of the terms high-powered and low-powered incentives, which connote difference in ability to elicit worker effort.' It is more informative to make distinctions between discrete and continuous pay and between inputbased and output-based pay.2 Pay structures can be summarized by the following equation: