Annullable Bonuses and Penalties

30 Pages Posted: 25 Feb 2004 Last revised: 6 Jun 2024

See all articles by Gerrit De Geest

Gerrit De Geest

Washington University in St. Louis - School of Law

Giuseppe Dari‐Mattiacci

University of Amsterdam; Tinbergen Institute; European Corporate Governance Institute (ECGI)

Jacques Siegers

Utrecht University - School of Economics

Date Written: March 23, 2009

Abstract

An annullable penalty is a sanction that is applied unless monitoring takes place and the agent is found non-shirking. An annullable bonus is a bonus that the agent receives unless he has been monitored and found shirking. Annullable penalties and bonuses stand in contrast with normal penalties and bonuses, which are only applied if monitoring has taken place. While real-life examples of annullable penalties are rare (an example is a sanction for which the burden of proof is reversed), there is a clear and often-discussed example of annullable bonuses: efficiency wages. Under efficiency wages all employees receive a bonus (an overpayment), except for those who have been monitored and found shirking.

This paper analyses under what conditions annullable bonuses or penalties make economic sense. On the one hand, annullable bonuses and penalties have a degree of ineffectiveness that is absent in their normal counterparts: the penalty paid by or the bonus paid to non-monitored agents does not improve their incentives. This ineffective part not only makes the expected sanction or bonus higher than necessary but creates an implicit tax on low monitoring levels and hence distorts monitoring choices. On the other hand, the annullable variants may change the ex post incentives of the agents (to come up with evidence) and the principal (to monitor as promised). As a result, annullable bonuses (such as efficiency wages) can be rational choices when the principal cannot credibly commit to paying bonuses with a certain probability, and annullable penalties can make sense when the agent needs an incentive to reveal information, or not to obstruct monitoring.

Keywords: effectiveness of sanctions, contract remedies, carrots and sticks, annullable penalties

JEL Classification: J41, K12, K31, K42

Suggested Citation

De Geest, Gerrit and Dari-Mattiacci, Giuseppe and Siegers, Jacques J., Annullable Bonuses and Penalties (March 23, 2009). International Review of Law and Economics, Vol. 29, pp. 349–359, 2009, George Mason Law & Economics Research Paper No. 04-10, Available at SSRN: https://ssrn.com/abstract=508702 or http://dx.doi.org/10.2139/ssrn.508702

Gerrit De Geest (Contact Author)

Washington University in St. Louis - School of Law ( email )

Campus Box 1120
St. Louis, MO 63130
United States
314-935-7839 (Phone)

HOME PAGE: http://www,degeest.wustl..edu

Giuseppe Dari-Mattiacci

University of Amsterdam ( email )

Postbus 15654
1001 ND
Amsterdam, Noord-Holland 1001 ND
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Jacques J. Siegers

Utrecht University - School of Economics ( email )

Kriekenpitplein 21-22
Adam Smith Building
Utrecht, 3584 EC
Netherlands

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