ECONOMIC THEORY AND ISSUES

Economics has a well-developed body of theoretical research that looks at how organizational incentives should be designed and uses the results of that work to understand why different organizations use different incentives. This body of research applies the general economic approach of explaining human behavior as resulting from individuals’ trying to get the best outcomes for themselves within the constraints of their environments. This general framework for understanding human behavior has proven to be quite powerful, although there are critiques that it misses important aspects of human psychology that limit the ability to determine the best outcome in the idealized way that economists assume (see, e.g., Ariely, 2008; Rabin, 1998).

The research on the use of incentives in organizations extends the general economic framework by analyzing differences in the objectives of the individuals who make up an organization. In particular, the work contrasts the objective of an organization as a whole—as defined by the owner or “principal” of that organization—with the objective of an individual worker or “agent.” As a very basic example, an owner probably cares about the organization’s overall profit while the workers care about their own pay, hours of work, and levels of effort. Because of the difference in these objectives, a worker in an organization may not behave in ways that will best achieve the owner’s goals for the organization—which can make the organization less productive and thereby make things worse for the workers indirectly by reducing employment or pay in the long run. To help correct such a situation, incentives can be used to encourage the workers to work toward the owner’s goals for the organization.

The classic example of the effect of incentive structures is to contrast the effect of paying workers by the hour with the effect of paying them by the amount of work they perform measured by some quantity of output. The latter is often known as a “piece rate,” derived from a manufacturing context in which a worker is paid for each piece produced. The owner of the company will want the workers to produce more per hour in order to increase profits: switching to a piece rate gives the worker an incentive to do so; paying by the hour may not do so. Sales commissions are one of the well-known ways in which piece rates are currently used in many industries. Empirical research has shown many situations in which simple piece rate incentives operate as the economic theory predicts (Prendergast, 1999), although the efficiency of incentives depends on the precise social relations that tend to grow up around piece work (see Burawoy, 1979; Sallaz, 2009).

Beyond the basic difference between paying by the hour and by the piece, there are important and subtle complexities that affect the way incentives operate. A number of contrasts in incentive structures provide



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