Can Second Chance Provisions Increase the Effectiveness of Penalty Contracts? Evidence from a Quasi-Field Experiment

Abstract

Companies often use penalty-based incentives in practice. Many of these companies give second chances to employees who have performed poorly in the past to improve performance. We predict that penalty contracts with second chance provisions will lead to higher employee performance relative to penalty contracts without such provisions. This is because the provision of second chances helps mitigate the negative impact of penalty contracts on the perceived fairness of the pay scheme. To test our hypothesis, we conduct a quasi-field experiment at two facilities of a manufacturing company for fourteen months. We implement a traditional penalty contract without a second chance provision in one facility and a similar penalty contract with a second chance provision in the other facility. We find results consistent with our theory. Our theory and results suggest that adding a second chance provision to penalty-based contracts can lead to performance benefits.

Keywords: penalty, second chance, fairness, performance

JEL Classification: M40, M41