With companies constantly seeking ways to gain competitive advantage, many employ the use of pay for performance i.e. those employees whose performance is better get more, but if such practices are managed poorly could they impede the effort of higher ability employees? A study at the University of California examined the effect of compensation distribution on the performance of higher-ability employees and found that such employees reduced their effort when not paid more than low ability colleagues, under pay for performance conditions. The findings also indicated that when managers are unclear on the ability of employees then compensation compression between high and low ability employees is more likely.
Key Topics: Compensation inequality; Compensation compression; Employee effort; Pay for performance
Title of Reviewed Article: Merit pay and wage compression with productivity differences and uncertainty
Researchers: Till Gross (Carleton University), Christopher Guo (Rand Corporation), and Gary Charness (University of California).
Publication: Journal of Economic Behavior & Organization, 2015, Vol. 117, pp. 233–247.
Setting the Scene
Compensation distribution is becoming an increasingly prominent issue both within companies and in wider society, particularly in the context of compensation inequality. When compensation is equitably distributed one result is typically greater compensation compression, where there is a relatively small difference between individual employee compensation levels. Such compensation compression however has also been shown to be the result of manager uncertainty about performance and productivity levels, rather than purely equity concerns (Charness & Kuhn, 2005).
Somewhat contrary to the idea of compensation equality is the concept of pay for performance, which is a strategy employed by many companies and allocates greater compensation to those employees contributing more (Lemieux et al., 2009). It is broadly established in past research that the compensation that is allocated to employees can affect their level of effort (Abeler et al., 2010) and research suggests that it is not purely the level of absolute compensation employees receive that affects their effort and performance, but also the relative compensation in comparison to peers (Akerlof & Yellen, 1990), as it develops their perception of compensation fairness (Falk & Knell, 2004; Clark & Senik, 2010). Card et al. (2012), for example, found that employees who are paid less than their peers are typically less satisfied in their job, while Bolton and Werner (2012) suggested that performance may also suffer and may be more pronounced among employees with greater ability.
This study put forward two primary research questions for examination:
Hypothesis 1 – “more productive workers who believe in merit pay will reduce their effort when not receiving a higher wage than their less productive co-workers, while less productive workers will not react much to relative wages.”
Hypothesis 2 – “The higher the degree of uncertainty about worker ability, the higher the wage compression.”
How the research was conducted
99 participants from the University of California took part in the study. In an experimental design, participants were designated randomly as managers or employees.
All participants completed an aptitude test. For those categorised as employees, the top 50% were categorised as high ability, while the bottom 50% were classified as low ability. Employees were made aware of their ability categorisation, while managers were not.
Three-person companies were formed randomly consisting of one manager, one high and one low ability employee. The experiment design assumed that with the same amount of effort the high ability employee would produce more than the low ability employee.
The manager was asked to distribution compensation to employees based on perceived employee ability, as they were not made aware of which was the actual high and low ability employee. Conditions were altered during the experiment to provide varying levels of information to managers.
Once employees were informed of their compensation and the compensation of their colleague, they were required to choose their effort level on a 1-6 scale.
Key Research Findings
Hypothesis 1 posited that an employee’s ability, and their corresponding productivity, is fundamental to understanding an effort response to their compensation in relation to others.
The results showed a significant decrease in effort by high ability employees when they were paid less than low ability employees, with the effect being greatest among those high ability employees who believed in the principle of merit pay. This same sensitivity to relative compensation was not found with low ability employees. These results support Hypothesis 1.
Support was also found for Hypothesis 2 and compensation compression, with managers differentiating compensation less between high and low ability employees when employee ability was unclear.
As information on employee ability decreased, average compensation paid by managers to employees was also found to decrease.
The results of this study are consistent with numerous others which found that employee compensation has a strong and significant effect on employee effort, while this study further establishes that high ability employees will reduce their output when they perceive there to be an inequitably distribution of compensation in relation to their less able colleagues, and particularly if they are paid less than these colleagues.
The results also indicate that the greater the uncertainty about employee ability, the more uniform compensation assigned by managers to high and low ability employees will be. The results indicated that this was indeed due primarily to uncertainty about actual ability rather than manager concerns about equality.
Organizational and Reward Implications
These results have some intriguing implication for reward practice. The findings suggest that pay for performance policies, which as prevalent in many companies, could be undermined by manager uncertainty in relation to ability and productivity. As the results suggest, as uncertainty increases in relation to employee ability, managers are more likely to err on the side of caution and award similar compensation to employees of varying abilities. This supports the idea often espoused in pay for performance literature that regular communication is a necessity between managers and employees for effective performance management and distribution of compensation, as it should reduce uncertainty and facilitate managers in making more informed decisions.
The results also highlight the importance of relative compensation in keeping employees happy, and particularly those of greater ability and performance. While absolute compensation is undoubtedly important, how employees are compensated relative to peers is likely to have a significant bearing on their effort levels, which companies should be mindful of for effective compensation management.
This study makes a number of important contributions to our understanding of compensation distribution and its effects on the effort of high ability employees, while also broadening our understanding of manager compensation distribution behaviour under uncertain conditions. While the experimental design of this study allowed for targeting of specific conditions, duplication of these findings in real world conditions will help to further strengthen the validity of the results.
Source Article: Gross, T., Guo, C., & Charness, G. (2015). Merit pay and wage compression with productivity differences and uncertainty. Journal of Economic Behavior & Organization, 117, 233-247.
Published by: Elsevier B.V.
For further details and access to the full journal article Click Here (subscription or payment may be required).
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Bolton, G., & Werner, P. (2012). Are efficiency wages equality wages? Exogenously induced fairness norms in working environments, Working Paper Series in Economics 56. University of Cologne, Department of Economics.
Card, D., Mas, A., Moretti, E., & Saez, E. (2012). Inequality at work: the effect of peer salaries on job satisfaction. American Economic Review, 102(6), 2981–3003.
Charness, G., Kuhn, P. (2005). Pay Inequality, Pay Secrecy, and Effort: Theory and Evidence, NBER Working Papers 11786. National Bureau of Economic Research, Inc.
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Lemieux, T., MacLeod, W. B., & Parent, D. (2009). Performance pay and wage inequality. Quarterly Journal of Economics, 124(1), 1–49.
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