Performance Incentives with Multiple Instruments

Abstract

We study the tradeoff between monetary bonuses and non-monetary prizes (such as promotions or perquisites) as instruments to overcome moral hazard. While money functions as a surplus-neutral transfer, prize allocations impact surplus and may be distorted to provide rewards or punishments. An optimal scheme punishes failure by withholding prizes while rewarding success with ex- tra prizes and possibly a monetary bonus. As desired effort increases, optimal prize incentives strengthen while monetary incentives often respond in a non- monotone fashion. Our results shed light on why career incentives are pervasive while performance pay is relatively uncommon in real-world organizations.