Compensation and Incentives: Practice vs. Theory

Authors

  • GEORGE P. BAKER,

    Assistant ProfessorSearch for more papers by this author
  • MICHAEL C. JENSEN,

    ProfessorSearch for more papers by this author
  • KEVIN J. MURPHY

    GraduateSearch for more papers by this author
    • Baker is Assistant Professor of Business Administration, Harvard Business School; Jensen is Professor of Business Administration, Harvard Business School, and La Clare Professor of Finance and Business Administration, William E. Simon Graduate School of Business Administration, University of Rochester; Murphy is Marvin Bower Fellow, Harvard Business School, and Assistant Professor, William E. Simon Graduate School of Business Administration, University of Rochester.

      This research is supported by the Division of Research, Harvard Business School, the Managerial Economics Research Center, University of Rochester, and the John M. Olin Foundation. The authors would like to thank Michael Beer for helpful discussions leading up to this paper, and Robin Cooper, Natalie Jensen, Kenneth Merchant, Richard Ruback, Robert Simons, and Richard Vancil for comments on an early draft; these people should not be held responsible for the authors' opinions or possible errors.


ABSTRACT

A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory—including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic—focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.

Ancillary