When Bonuses are Contraindicated

Should companies pay out performance-related bonuses? It turns out that such

payments might well be counterproductive:

The logic of bonus payments itself seems straight-forward: by paying a bonus

on the condition of success, the successful outcome becomes more attractive

to the agent and he puts in more effort to increase the likelihood of success.

But do bonus payments necessarily increase effort and the likelihood of success?

Here, I examine this question and find that the answer is “no.”

The logic is quite clever. Let’s say I get a fixed bonus if I manage to achieve

a certain result, and that working a lot harder will make that result a bit

more likely. Then I have two choices. The first choice is that I work a lot

harder, in which case the probability of getting a successful result goes up

– a bit. The cost of this choice is high: it involves a lot of hard work.

The benefit is low: a relatively small increas in the likelihood of me receiving

my bonus.

On the other hand, I can choose to work less. The cost of this choice is low:

there’s now a slighly smaller chance that I will receive my bonus. But the benefit

is high: lots more leisure, and a substantial chance of receiving the bonus

without actually doing any extra work for it, which is nice.

Chris Dillow applies

this theory to the real world of CEOs:

I suspect this might be true for quite a few CEOs with stock options. They

might figure:

It’s going to be really hard work to genuinely improve this business.

And even if I do so, it might not raise the share price by much, because

equity analysts are stupid buggers and the company’s share price depends

upon stock market conditions. I’ll just talk a good game and hope

the market rises – as it usually does over time – taking the company‘s

share price up with it. If I must do something, I’ll increase the

gearing of the company by buying back shares. That’s easy to do, and

it’ll increase the share’s beta and hence its chances of the

share price rising a lot if the market rises.

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