This blog post examines why incentive contracts are important for both companies and employees, focusing on their types and effects.
Why are incentive contracts necessary?
Companies want employees to exert more effort than the compensation provided, while employees want more compensation from the company relative to their effort. To mitigate this conflict of interest between companies and employees, an incentive contract is a promise ensuring that the compensation received by the employee reflects their effort. There are two methods for incentive contracts: using explicit contracts and implicit contracts.
Explicit Incentive Contracts
Explicit contracts are promises enforceable by third parties like courts, so they must be based on objectively verifiable conditions. Since an employee’s effort cannot be objectively measured, an explicit incentive contract is a promise to compensate the employee based on performance—the result of effort—rather than effort itself. This contract provides a very strong incentive for the employee to increase their effort.
For example, if the compensation system for a worker is ‘fixed salary + 𝜶 × performance’ (0 ≤ 𝜶 ≤ 1), as 𝜶, which represents the incentive intensity, increases, the worker will exert additional effort beyond the baseline effort required for the fixed salary, motivated by the performance-based pay. This is because, unlike the baseline effort, the worker receives a larger share of the rewards from the additional effort as 𝜶 increases. Therefore, increasing 𝜶 leads to greater additional performance as the worker’s effort level rises. Consequently, even if a larger share of this additional performance is given to the worker, the firm’s profits increase.
However, due to two problems inherent in explicit incentive contracts, increasing 𝜶 can sometimes reduce the firm’s profits. First, explicit incentive contracts make the worker’s income uncertain. This is because the worker’s performance is influenced not only by their effort but also by contingent factors such as work conditions, circumstances, and luck. To make workers accept this income uncertainty, firms must pay them additional compensation that acts as a risk premium. Therefore, as 𝜶 increases, the compensation firms must pay workers rises, potentially reducing firm profits.
Second, explicit incentive contracts create incentive distortion problems, where workers focus their efforts on maximizing their compensation. This is because some aspects of performance are easy to measure, while others are not. If workers neglect important tasks that are difficult to measure and thus undercompensated, it can harm the company’s overall performance. Therefore, when 𝜶 increases, the problem of incentive distortion worsens, potentially reducing corporate profits.
Implicit Incentive Contracts
When finding appropriate performance metrics is difficult and incentive distortion is a significant concern, implicit incentive contracts may be more effective. An implicit incentive contract compensates workers through bonuses, welfare benefits, promotions, etc., based on a subjective evaluation of their effort, regardless of actual performance. An implicit contract is not a legally enforceable agreement. Instead, it is understood that parties voluntarily act to meet each other’s expectations when maintaining a cooperative relationship is beneficial in the long term.
There is no legal means to force a party to fulfill an implicit contract if they believe the short-term gain from betraying the other party’s expectations is significant enough to justify severing the cooperative relationship. However, once trust is lost, voluntary cooperation from the other party can no longer be expected. Therefore, when relying on implicit incentive contracts, it is crucial to ensure employees trust that the company’s evaluations and rewards are fair.
Conclusion and Additional Considerations
When selecting the type of incentive contract, companies must consider various factors. For example, they must assess whether employee performance can be objectively measured, how much uncertainty employees can tolerate, and how important it is to maintain a cooperative relationship over the long term. It is also necessary to design an incentive structure that fits the company culture and organizational characteristics. When incentive contracts are well-designed and implemented, they can yield outcomes beneficial to both the company and its employees.
Therefore, for the successful operation of incentive contracts, it is crucial to thoroughly understand the advantages and disadvantages of explicit and implicit contracts and to appropriately combine and apply them according to the situation. Companies should continuously improve their incentive systems through ongoing monitoring and feedback, thereby maximizing both employee motivation and corporate performance simultaneously.
