Performance Pay's BFFs!

In life, some things just go together – and nothing goes together better than best friends. Lucy was good on her own, but when she and Ethel were together, it was magical. Sometimes it takes a best friend to bring out the best in each of us. This is certainly true when it comes to performance pay.

One of performance pay’s BFFs is motivational language. In a previous post I wrote about this special relationship: employees respond to motivational talk by increasing their performance only if they also receive performance pay, and performance pay decreases performance unless it is accompanied by motivational talk. 

But recent research suggests that performance pay have another BFF: a high-wage policy. An article by Uwe Jirjahn published in Managerial and Decision Economics suggests that performance pay – whether individual based, group based or profit sharing – increases productivity only when it is coupled with a high-wage policy.

The central issue addressed in this research is the interaction of pay level and pay method. The author explores the question of whether the effectiveness of performance pay in increasing productivity is strengthened when it is coupled with a high-wage policy. The hypothesis is that performance pay on its own does not automatically provide stronger incentives. Performance pay can lead to disincentives if it undermines intrinsic motivation or violates norms of fairness. Jirjahn posits that to truly be effective in increasing productivity, performance pay needs to be coupled with a high-wage policy to maintain intrinsic motivation.

What is a high-wage policy? According to Jirjahn, high-wage policies exist when management’s view that “it is important or very important to motivate workers by paying wages above the level specified in collective agreements.” The author notes that in Germany it is commonplace for “non-covered firms” (those without collective bargaining agreements) to use collective bargaining agreements when making decisions about their compensation policies. 

Using data from the Hanover Panel – a four-wage panel data set with representative data from manufacturing establishments in the federal state of Lower Saxony (in northwestern Germany) with more than 50 employees – the author finds no evidence that by themselves, neither performance pay nor a high-wage policy has any impact on productivity. However, combining performance pay with a high-wage policy significantly raises productivity. According to the author, this finding supports the view that:  

“Performance pay needs to be combined with a high-wage policy in order to involve positive incentive effects. Sufficiently high rewards may be required to foster perceptions of fairness and to offset the loss of intrinsic motivation so that workers positively respond to performance pay.”

Regardless of the type of incentive pay studied – individual-based performance pay, group-based performance pay, and profit sharing – this pattern holds true.

This study has an important practical implication: using performance pay may not be an effective means of increasing worker productivity while simultaneously reducing labor costs. Some have argued that altering pay mix to emphasize incentive pay, minimize the role of base-building merit pay increases, and eliminate increases not tied to performance (i.e., increases based on seniority) can allow an organization to at least control labor costs, if not reduce them. The findings of this research indicate that to truly be effective in driving productivity, performance pay cannot take the place of a strong base pay policy. Both are necessary for the benefits of performance pay to be realized. 

If the findings of this study can be generalized to organizations outside of manufacturing firms in Lower Saxony with more than 50 employees, the message to employers is clear: if you want increased productivity, you have to pay for it – through performance pay coupled with a strong base pay program. 

Stephanie Thomas, Ph.D., is a Lecturer in the Department of Economics at Cornell University. She teaches undergraduate and graduate courses on economic theory and labor economics in the College of Arts and Sciences and in Cornell’s School of Industrial and Labor Relations. Throughout her career, Stephanie has completed research on a variety of topics including wage determination, pay gaps and inequality, and performance-based compensation systems. She frequently provides expert commentary in media outlets such as The New York Times, CBC, and NPR, and has published papers in a variety of journals.

This post originally appeared on Compensation Cafe
Author: Stephanie Thomas