Incentive Compensation in a Corporate Hierarchy

By Michael Gibbs

Abstract
This paper examines incentive compensation for middle managers in a typical hierarchical firm. I develop a model of the tradeoff between within job and promotion based incentives in an optimal incentive scheme in a hierarchy. This is used to examine the incentive scheme used by the firm. Promotions are used to sort employees by ability; they also are an important source of incentives. On the other hand, the promotion system and structure of wages across the hierarchy does not seem to be designed and altered explicitly to manage incentives. Within job incentive compensation is neither high powered nor trivial. It comes about through raises and the possibility of a bonus (and less so by the size of the bonus). Both are based on coarse measures of performance: three levels of performance ratings. Demotions and dismissals are not used as a key part of the incentive scheme. Performance and incentives decline for managers who are passed over for promotion. However, this is not because the firm optimally adjusts within job incentives for changes in promotion chances or employee abilities. There is no evidence that the firm trades off within and across job pay for performance. The decline in motivation for those who stay in a job appears to come from the loss of promotion based incentives. I conclude that the firm runs a very simple and naive incentive compensation scheme. The implications of these findings for organizational innovation and adaptation are discussed.

Materials provided are for Educational Use Only. All articles are the sole Copyright of their respective publishers.