The Behavioral Promise and Pitfalls in Compensating Store Managers

Abstract

Compensation systems have been shifting away rapidly from a fixed wage contractual payment basis. Many companies today are creating incentive compensation contracts to reward hardworking employees for jobs well done. Profit-sharing (“sharing compensation contract�? thereafter) and target-with-bonus (“target compensation contract�? thereafter) are two common performance based compensation contracts, prevalent in business. We theoretically and behaviorally studied the sharing and the target compensation contracts in an operational context where a firm sets the parameters of the compensation contracts, and a store manager, after observing the compensation contract offered to him, chooses his effort level (unobservable by the firm) and makes ordering decisions for the store. Our experimental data suggests systematic deviations from the theoretical benchmark, and reveals behavioral promise and pitfalls under the two compensation contracts. In particular, the store manager is more willing to exert high effort under the target contract, all else equal. On the other hand, the store manager is also more likely to punish the firm for perceived “unfair�? offers, by submitting an extremely low order quantity. We find that bounded rationality plays an important role in driving a higher effort rate under the target contract than the sharing contract. We introduce a new formulation of the fairness concerns, referred to as by-state fairness where individuals, instead of considering whether or not the expected profits received are fair, consider the fairness in potential realized outcomes. This new formulation explains why managers are more likely to order very little as to punish the firm in the target contract. In addition, we conduct validation experiments to verify our behavioral explanation.