Performance pay, stress, and alcohol and drug use

Employers use performance pay to incentivise their workers to work harder. However, that increases workers' stress and uncertainty, both of which may in theory lead to an increase in workers' use of alcohol and drugs as a coping mechanism. In a new article published in the Journal of Population Economics (ungated earlier version here), Benjamin Artz (University of Wisconsin-Oshkosh), Colin Green (Norwegian University of Science and Technology) and John Heywood (University of Wisconsin-Milwaukee) test this theory, using data from the U.S. National Longitudinal Survey of Youth 1997 (NLSY). The NLSY collects data on whether the respondents received performance pay ("tips, commissions, bonuses, incentive pay, and a small “other” category") in each wave, as well as marijuana or alcohol use within the previous 30 days, and other drug use (which they refer to as 'hard drugs') within the last year. The sample size is over 60,000 observations.

The problem with a simple analysis here is that the types of people who are more likely to accept a job with performance pay (i.e. younger people, and people who are less risk averse) are also those who are more likely to consume alcohol and drugs. So, a positive correlation between performance pay and alcohol and drug use is to be expected because of 'selection bias'. Artz et al. use a number of techniques to get around this bias:

First, we include proxies for risk preferences, ability, and personality incorporating sophisticated error structures... Second, we use the survey’s panel structure to hold constant time-invariant worker fixed effects that could include unmeasured risk preferences or ability. Third, we recognize that changes in unmeasured worker characteristics can lead to both job change (and so performance pay receipt change) and to a change in substance use. We respond by controlling for job match fixed effects. Thus, we examine the change in individual workers’ substance use when their employer changes their performance pay status (even as they remain in the same detailed occupation).

So, they control for risk preferences (albeit imperfectly - I'll come back to that point), and then in their most restrictive specification the fixed effects reduce their comparisons to the same worker, working for the same employer. Essentially, they look at what happens when a worker goes from not having performance pay, to having performance pay (or vice versa), while still working for the same employer. In the first specification (excluding risk preferences and the fixed effects), they find that:

The main estimates of interest reveal large, positive, and statistically significant, relationships between performance pay and all types of substance use. The odds ratio... indicate that holding other determinants constant, performance pay workers have odds that are 29% higher for marijuana use, 35% higher for hard drugs use, and 45% higher for alcohol consumption.

The inclusion of risk preferences (which are measured only in the 2010 wave) do not change the estimated relationships greatly. Then, in their most restrictive specification (with worker-employer-job fixed effects), they find that:

The results indicate a 29% increase in the odds ratio for marijuana use, a 26% increase in the odds ratio of hard drug use, and a 34% increase in the odds ratio alcohol use... In sum, the results... indicate that the relationship between PRP receipt and marijuana, hard drugs, and alcohol use persists despite worker sorting on time fixed unobserved worker characteristics, or worker sorting across employers.

A potential problem with these analyses is that risk aversion decreases as people get older, and alcohol and drug use also decrease, and so even though they control for risk aversion measured at a single point in time, or control for job-match fixed effects, they still potentially don't fully eliminate the selection bias. However, it's difficult to see how this research design could be much improved upon. While jobs can be randomised to receiving performance pay, researchers couldn't force workers to accept the performance pay condition, so a randomised experiment would not work.

Performance pay does increase incentives for work effort in some jobs, but that doesn't mean that it comes without cost. Some of the cost is of course borne by the employer, but workers also must endure a more uncertain and stressful work environment. The results of this study are consistent with that story, and that some workers respond by self-medicating with alcohol and drugs.

[HT: Marginal Revolution]

Why performance pay may underperform

Tim Harford wrote an interesting piece last month about performance pay. He wrote:

Here’s an age-old management conundrum: who should be rewarded for high performance, and how? As Diane Coyle, the economist and former adviser to the UK Treasury, recently observed in this newspaper, the answer to the question is usually self-serving. Simple and easily monitored jobs, such as flipping burgers, are natural candidates for performance incentives. Yet somehow it’s the inhabitants of the C-suite who tend to pick up bonuses, despite the fact that their complex, hard-to-measure jobs are poorly suited to the crude nature of performance-related pay.

Harford (as always) does a great job of summarising the state of research in this area. He correctly identifies that financial rewards don't work in all situations. I'm going to use this post to highlight the factors that must be in place for a performance pay scheme to work well - the absence of one or more of these factors will lead to a performance pay scheme that won't work so well.

First though, some background. Why have performance pay? Employers face a problem we refer to as the principal-agent problem (a specific type of moral hazard). The employer (the principal) engages an employee (the agent) to work on their behalf. However, the goals of the employee are rarely perfectly aligned with the goals of the employer. So, because the employer cannot easily monitor all of the employee's activities, the employee can engage in activities that are not necessarily in the best interests of the employer (like goofing off). Rewarding employees for meeting set targets (and performance pay more generally) is one way of re-aligning the interests of the employee with those of the employer (other options include closer monitoring of employees, and paying efficiency wages, which I have previously discussed here). However, for performance pay to work well a number of things factors need to be present.

First, employees must respond to incentives. This seems like a given, since one of the assumptions economists make is that people respond to incentives. However, it might not always be true. If employees are already highly paid, and the performance payment is small, it might not be enough incentive to encourage greater work effort. So, if you are selling farm machinery, for performance pay to work well your salespeople must be willing to try to earn more sales to capture the performance pay (e.g. commissions).

Second, employees' output must be sensitive to their effort. If employees work harder but the additional effort does not enable them to produce (or sell) more, then rewarding them with performance pay simply won't work well. Why waste your time working harder if it doesn't lead to more output (and higher pay)? So, for performance pay to work well your farm machinery salespeople must be able to sell more tractors if they work harder (at trade shows, visiting potential clients, etc.).

Third, employees' output must be measured easily. If you are going to reward employees for their performance, you must be able to objectively measure their performance. On top of that, employees must be able to believe that the measurement of their performance is accurate. Measurements that are not credible will not encourage employees to work harder. So, for performance pay to work you must be able to know how many tractors each salesperson is selling.

Fourth, employees must not be too risk averse. Risk averse people prefer a higher degree of certainty. Performance pay reduces the certainty of employees' incomes, so if they are highly risk averse they will prefer to work elsewhere (this may or may not be a good thing!). So, your farm machinery salespeople must be willing to accept some likely fluctuations in their salary (as their sales increase or decrease from month to month).

Finally, the level of risk that is beyond the employees' control must be low. If employees' performance depends on their own effort, but also on other factors that are beyond their control, then rewarding high performance may not necessarily increase work effort. This will be a greater problem the greater the share of employee performance that is driven by the external factors. So, if farm machinery sales are driven more by the weather and how farm profits are going, and less by the efforts of the individual salespeople themselves, it will not work so well.

On that last point though, one work-around is to reward employees for their relative performance, i.e. their performance relative to their peers, to industry benchmarks, or to agreed targets. However, it is possible to take performance pay too far - to the extent where competition between different employees is encouraged to an unhealthy extent. In any case, performance pay is one method of dealing with underperforming employees - but if the factors noted above are not present the performance pay scheme itself may well underperform.