Is Pay for Performance Detrimental to Innovation?

• Published in: Management science Vol. 59; no. 7; pp. 1496 - 1513
• Main Authors: Ederer, Florian, Manso, Gustavo
• Format: Journal Article
• Language: English
• Published: Linthicum INFORMS 01.07.2013; Institute for Operations Research and the Management Sciences
• Subjects: Business creativity; Business innovation; Business strategies; Creativity; Economic aspects; Employee incentives; Employee motivation; Entrepreneurship; Executive compensation; Experimental economics; Experiments; Financial incentives; Golden parachute; Golden parachutes; Hypotheses; Incentive pay; Incentive plans; Incentives; Innovation; Innovations; Laboratories; Management science; Methods; Monetary incentives; Motivation; motivation incentives; organizational studies; P values; Pay for performance; personnel; Product mixes; Productivity; Psychological aspects; Psychological research; R&D; Research & development; Research and development; Risk aversion; Statistical significance; Studies; Wages; Wages & salaries; United States
• ISSN: 0025-1909; 1526-5501
• DOI: 10.1287/mnsc.1120.1683

Previous research in economics shows that compensation based on the pay-for-performance principle is effective in inducing higher levels of effort and productivity. On the other hand, research in psychology argues that performance-based financial incentives inhibit creativity and innovation. How should managerial compensation be structured if the goal is to induce managers to pursue more innovative business strategies? In a controlled laboratory setting, we provide evidence that the combination of tolerance for early failure and reward for long-term success is effective in motivating innovation. Subjects under such an incentive scheme explore more and are more likely to discover a novel business strategy than subjects under fixed-wage and standard pay-for-performance incentive schemes. We also find evidence that the threat of termination can undermine incentives for innovation, whereas golden parachutes can alleviate these innovation-reducing effects. This paper was accepted by David Hsu, entrepreneurship and innovation.