The Psychological Costs of Pay-for-Performance: Implications for the Strategic Compensation of Employees

45 Pages Posted: 10 May 2011 Last revised: 21 Feb 2013

See all articles by Ian Larkin

Ian Larkin

University of California, Los Angeles (UCLA) - Anderson School of Management

Lamar Pierce

Washington University, Saint Louis - John M. Olin School of Business

Francesca Gino

Harvard University - Business School (HBS)

Date Written: July 27, 2011

Abstract

Most research linking compensation to strategy relies on agency theory economics and focuses on executive pay. We instead focus on the strategic compensation of non-executive employees, arguing that while agency theory provides a useful framework for analyzing compensation, it fails to consider several psychological factors that increase costs from performance-based pay. We examine how psychological costs from social comparison and overconfidence reduce the efficacy of individual performance-based compensation, building a theoretical framework predicting more prominent use of team-based, seniority-based, and flatter compensation. We argue that compensation is strategic not only in motivating and attracting the worker being compensated, but also in its impact on peer workers and the firm’s complementary activities. The paper discusses empirical implications and possible theoretical extensions of the proposed integrated theory.

Keywords: compensation, pay, incentives, principal-agent models, motivation, psychology

Suggested Citation

Larkin, Ian and Pierce, Lamar and Gino, Francesca, The Psychological Costs of Pay-for-Performance: Implications for the Strategic Compensation of Employees (July 27, 2011). Harvard Business School NOM Unit Working Paper No. 11-056, Available at SSRN: https://ssrn.com/abstract=1836405 or http://dx.doi.org/10.2139/ssrn.1836405

Ian Larkin (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Lamar Pierce

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-5205 (Phone)

Francesca Gino

Harvard University - Business School (HBS) ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

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