Bonus Culture

The comments I received on my post about a maximum wage were interesting for many reasons. In this post I just want to focus on one common misperception. This is that a maximum wage, because it interferes with the market, must be distortionary and therefore something that should tend to be avoided. This in turn assumes that the actual economy approximates the competitive efficient allocation students learn about in Econ 101, which is what neoliberals would like people to believe.

To see why this might well not be true when it comes to high pay, I want to briefly discuss a paper (NBER version here) by Roland Bénabou and Jean Tirole, which has the title of this post. I will try and make my discussion as non-technical as possible.

The basic idea is as follows. Jobs involve two types of activity or output, one of which is measurable and one is not. To reflect this, pay involves two components: a fixed component, which the worker always gets, and a performance element (the bonus) which depends on the worker’s measured output. The firm wants the worker to undertake both types of activity, so it sets the appropriate relationship between the two elements of pay to make sure the worker puts the right amount of effort into each type of activity. I will talk about what these two types of activity might be in practice below.

So far, so good. But now we add an information problem. There are two types of workers: the ordinary and the talented. The talented worker is much better at producing the measurable output. The firm cannot tell the two types apart, but it would naturally like to attract some of the more talented workers. One way it can do this is to offer two types of remuneration package: a ‘low bonus’ type and a ‘high bonus’ type. Talented workers will be attracted to the high bonus package, because their talent means that they can achieve high measured output (and therefore high pay) with relatively little effort.

This is useful for the firm, but it creates a problem. The bonus payment is now doing two jobs: allocating worker effort between activities, and attracting talented workers. In these circumstances, the bonus payment can depart from its efficient level. In particular the paper shows (p13) that in a competitive labour market, bonus payments designed for talented workers will be too high, in the sense that they lead to these workers putting too much effort into the measured activity, and too little into the other activity.

So what might these two activities (one measurable, one not) be in practice. The paper suggests, for measurable activities, things like sales, output, trading profits, and billable medical procedures, and for immeasurable activities things like intangible investments affecting long run value, financial or legal risk-taking, and cooperation among individuals or divisions. So the problem is that, in an effort to attract talented workers, the firm over incentivises effort on achieving tangible short term goals at the expense of work on intangible, longer term objectives.

The relationship to my discussion of a maximum wage should now be clear. To quote from the paper: “Turning to policy implications, we show that a cap on bonuses can restore balance in agents’ incentives, and even re-establish the first best, as long as it does not induce employers to switch to some alternative “currency” to screen employees.”

If you want to think about how this idea relates to alternative models of executive pay and competition for talent, I would encourage you to read section 1.1 of the paper, which is not too technical. The paper also contains a lot more that will be of interest to economists.

The general point I want to make is this. We can think about the minimum wage as an unfortunate interference in the market which can nevertheless be justified on equity grounds, or as a means of reducing poverty. However we can also see it as a way of increasing the efficiency of the economy, because many employers of low paid workers can exploit their monopoly power to pay wages that are below the efficient level (monopsony). Exactly the same may be true of the maximum wage. It could be that top pay is inefficiently high because executives have monopoly power, or it could be as this paper suggests because the firm wants to attract unobservable talent. I see no reason to presume that the dramatic increase in top pay reflects increases in the productivity of those workers.