The Federal Reserve Board eagle logo links to home page
Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page The Welfare Effects of Incentive Schemes
Adam Copeland and Cyril Monnet

Abstract: This paper computes the change in welfare associated with the introduction of incentives. Specifically, we calculate by how much the welfare gains of increased output due to incentives outweigh workers' disutility from increased effort. We accomplish this by studying the use of incentives by a firm in the check-clearing industry. Using this firm's production records, we model and estimate the worker's dynamic effort decision problem. We find that the firm's incentive scheme has a large effect on productivity, raising it by 14% over the sample period. Using our parameter estimates, we show that the cost of increased effort due to incentives is equal to the dollar value of a 9% rise in productivity. Welfare is measured as the output produced minus the cost of effort, hence the net increase in welfare due to the introduction of the firm's bonus plan is 5%. Under a first-best scheme, we find that the net increase in welfare is 6%.

Keywords: Principal-agent theory, personnel economics

Full paper (254 KB PDF)

Home | FEDS | List of 2003 FEDS papers
To comment on this site, please fill out our feedback form.
Last update: February 25, 2003