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What role does overconfidence play in non-linear incentive schemes?

In this paper, HBS professor Ian Larkin and Ross School of Business professor Stephen Leider explore the role that the behavioral bias of overconfidence may play in explaining the prevalence of non-linear incentive schemes. They conclude that the linearity or non-linearity of an incentive system could play an important role in sorting employees according to their level of confidence; in addition, there may be three possible benefits to having overconfident employees. Key concepts include:

  • First, overconfidence is valuable for certain job functions; for example, salespeople lose deals much more frequently than they win them, and being overconfident may help them be effective despite the many failures they go through.
  • Second, absent non-linear contracts, employers and overconfident employees may have a difficult time agreeing to a compensation scheme in the first place. Non-linear systems allow employers and employees with fundamentally different beliefs form compensation agreements.
  • Third, the non-linearity of an incentive system may allow firms to lower their wage bill. A convex scheme, for example, may allow firms to take advantage of overconfident employees’ systematic and persistent bias toward believing they will perform well.
  • The study confirms recent findings in psychology literature that overconfidence is not an individual trait so much as a trait around a specific task.

Abstract

Non-linear incentive schemes are commonly used to determine employee pay, despite their distortionary impact. We investigate possible reasons for their widespread use by examining the relationship between convex pay schemes and overconfidence. In a laboratory experiment, subjects chose between a piece rate and a convex pay scheme. We find that overconfident subjects are more likely than others to choose the convex scheme, even when it leads to lower pay. Overconfident subjects also persist in making the mistake despite clear feedback. These results suggest non-linear pay schemes may help companies select and retain overconfident workers, and may reduce the wage bill.

Source