The W effect of incentives

Transcription

1 The W effect of incentives Uri Gneezy The University of Chicago Graduate School of Business October 13, 2003 Abstract: Much of economic theory is based on the assumption that incentives and performance are positively related. In some cases, however, introducing extrinsic incentives might change the perception of the activity and reduce its performance. I show that this puzzling contrast can be resolved if we consider the size of the incentives. A decrease in productivity is observed for small, but not for large incentives. A plot with incentives on the horizontal axis (such that fines are on the negative side and rewards on the positive), and performance on the vertical axis, results in a W-shaped graph. I use a proposer-responder game to demonstrate this W effect. When proposers are asked to simply dictate allocation, they give the responder significantly more money than when the responder can counter with either a small reward or a small fine. When the retaliation option of the responder is large enough, however, proposers send significantly more generous offers than in all other treatments. Key words: Incentives; social norms; extrinsic and intrinsic motivation 1

2 1. Introduction In the standard economic model of agency theory, introducing an extrinsic motivation, such as money, always motivate the agent and cannot lower effort. This occurs because without extrinsic motivation, effort is necessarily at the lowest possible level (Kreps, 1997). Moreover, effort increases monotonically with incentives (positive or negative). 1 This basic assumption is supported by a large body of empirical evidence (e.g., Lazear, 2000, Prendergast, 1999). In psychology, the attempt to understand what motivates people led early researchers to focus on two types of explanations: basic biological needs of survival and procreation (e.g., hunger, sex), and extrinsic rewards or punishment. These two types of explanations imply that we are motivated by the need or desire to achieve particular goals. But some of the activities we do are not motivated by either biological needs or extrinsic motivations. To explain why we engage in such activities, researchers introduced intrinsic rewards and intrinsic motivation, in which the reward is inherent to the activity (Woodworth, 1921; White, 1959; see Sansone and Harackiewicz, 2000 for discussion). In the early 1970s a new research direction started to question the nature of intrinsic and extrinsic motivation, and in particular the assumption that intrinsic motivation pushes behavior in the same direction as extrinsic motivation (e.g., Deci, 1971; Lepper, Greene and Nisbett, 1973; Kruglanski, Alon and Lewis, 1972). Since then, in contrast with the basic economic assumption, ample amounts of evidence (that will be surveyed below) show that extrinsic incentives may have a negative effect on 1 Provided, of course, that income effects are smaller than substitution effects, as is always the case in the literature discussed here. 2

3 performance. The basic argument is that extrinsic motivation might change the perception of the activity and destroy the intrinsic motivation to perform it when no apparent reward apart from the activity itself is expected. 2 We are left with a contrast between economic theory and evidence showing that extrinsic motivation is productive, and some psychology theories and evidence showing that extrinsic motivation is counterproductive. The first goal of this paper is to study the conditions under which each literature is supported by the data. In particular, I focus on the size of the incentive, arguing that once extrinsic incentives are present, people react to them in a monotone way: higher incentives result in more effort (Gneezy and Rustichini, 2000a; Gneezy and Rustichini, 2003). However, in some cases this reaction is not monotonic: when moving from no incentives to small incentives, performance goes down, and only when incentives are increased, does it go up (in some cases we observe discontinuity at zero: the mere introduction of extrinsic incentives destroys the intrinsic motivation). While small incentives are not necessarily better than no incentives, once the extrinsic motivation is large enough, it results in a better performance than the noincentive case. The different conclusion reached by psychologists and economists is the result of different resolution used to study the problem. The second goal of this paper is to stress the close connection between the effect of positive incentives and similar effects observed in negative incentives, such as fines and punishments. In general, the discussion of the counter productivity of negative extrinsic incentives is much smaller than the discussion of positive extrinsic incentives, 2 Other streams in psychology concentrated on different effects of incentives. For example, the psychology literature on fines and sanctions is very much in line with the economic and legal literature, claiming e.g., that when negative consequences are imposed on a behavior, they will produce a reduction of that particular respond. See Gneezy and Rustichini (2000a,b) for surveys of these streams of research. 3

4 and very few papers have tried to connect the two. 3 In this paper I present the results of one experiment in which the only difference between the treatment involving positive and the treatment involving negative incentives was one word in the instructions. I find that the model found for positive incentives works well for negative incentives: a nonmonotonicity close to zero, and then a monotone economic reaction when the fines are increased. The third goal of this paper is to combine the positive and negative findings into one environment that can explain the seemingly puzzling difference between the economic and psychological findings. I plot the findings such that incentives are on the horizontal axis with no extrinsic motivation at the zero, and fines (rewards) on the negative (positive) side. A measure of performance or effort is plotted on the vertical axis. The resulting function of performance is a W-shaped graph. Hence I call it the W effect of incentives. I suggest the W-shaped function as a way to understand the nonmonotonicity of incentives. To demonstrate this, I use a proposer-responder game, in which I show that the proposers behavior follows the W-shaped function. 2. Thought experiments I start with some thought experiments to demonstrate that introducing monetary payoffs may be counterproductive. Consider the following two scenarios regarding a policy aimed at protecting the environment by recycling soda cans. 3 See the survey in Fry and Jegen (2001), Gneezy and Rustichini (2003), and Gachter (2003). See also McDaniel and Rutstrom (2001) and Rutstrom (2002) who study the detrimental effect associated with the cost of decision making. 4

5 Scenario 1a: You live in Chicago where recycling soda cans is not extrinsically rewarded. On a freezing morning, you see your friend with a large bag full of soda cans on her way to the recycling container. Clearly you are impressed by her devotion to the environment. Scenario 1b: The same as above, but a five cent reward for each recycled soda can is in place. Now you see your friend carrying a large bag of soda cans to the recycling container (where she can collect her reward). In the first scenario, the action is attributed to caring for the environment, which is an important social norm in many places. In the second scenario, however, the same behavior is attributed to being cheap. Not only may other peoples perceptions of the activity change by the introduction of external incentives, but also the person recycling might perceive the act differently. In the scenario with no external rewards, it was care for the environment that motivated recycling; in the second scenario, the addition of the extrinsic motivation may have changed the perception of the activity. A classical example of this type of reaction is discussed by Titmuss (1970) and Upton (1973), who compared blood donation in places with and without monetary compensations. Their conclusion was that the paid system resulted in fewer donations, and in different social characteristics of donors. A different type of counterexample to the basic economic intuition results from an extrinsic motivation that causes a person to feel insulted. Consider scenario 2: 5

6 Scenario 2a: You meet an attractive person, and in due time you tell that person I like you very much and I would like to have sex with you. Scenario 2b: The same as 2a, but now you say I like you very much and I would like to have sex with you. To sweeten the deal, I am even willing to pay you $10. If money was the only difference between scenarios 2a and 2b, with all else being equal, you would conclude that your partner in the latter scenario should be happier than in the former. However, sometimes introducing extrinsic motivation changes the perception of the interaction. Offering monetary rewards might be insulting and as a result people s willingness to cooperate or invest effort will decline. 4 Empirical evidence in support of this shows, for example, that volunteers work is negatively affected by the introduction of small payments. More generally, this may affect employer-employee relations: when an extra marginal payment is introduced on top of a lump sum wage, the assumption that this is the only change and all else is equal is not always true (see Frey and Goette, 1999, Gneezy and Rustichini, 2000a). Scenarios 1 and 2 show, intuitively, that the introduction of positive rewards for an activity might change the perception of this activity, and that this change in perception is not always in the desired direction. Now consider the counterproductive effect of negative incentives: Scenario 3a: Your child is in a daycare center and you are supposed to pick her up at 4pm. There is no specified sanction for picking up the child late. 4 Not all extrinsic motivation is detrimental in this scenario. For example, flowers might have a positive effect on behavior. 6

7 Scenario 3b: The same as scenario 3a, but a $3 fine is used by the daycare center as a sanction for late coming parents. Gneezy and Rustichini (2000b) present the results of a field study in a group of daycare centers in Israel that studied the difference between daycare centers with and without fines. Parents used to arrive late to pick up their children, forcing a teacher to stay after closing time. The introduction of a $3 fine for late-coming parents resulted in an increase in the number of late-coming parents. It is also interesting to note that after the fine was removed, no reduction occurred. That is, once parents got used to coming late, removing the fine did not reverse this tendency. One way to explain such a behavior is that before the fine was introduced, the parent did not really know how bad it is to be late because the contract was incomplete and did not a sanction. Parents use the fine as information regarding the severity of being late; the relatively small fine indicates that it is not that bad. This contradicts the deterrence hypothesis, according to which introducing sanctions that leave everything else unchanged will reduce the occurrence of the behavior sanctioned. Negative incentives do not have to be in the form of a fine, as scenario 4 demonstrates: Scenario 4a: You live in a small town and have a private house with a backyard. Garden garbage is collected once a week. You must use special bags, provided by the city at no 7

8 charge, for disposal. On these bags you see an advertisement asking you to reduce the amount of garbage you produce in order to protect the environment. Scenario 4b: The same as scenario 4a, but now the authorities are charging 5 cents per bag. Anecdotal observation shows that charging a small amount of money per bag may increase the amount of garbage produced. The reason might be (like in the soda cans example) that the perception of the act is changed by the introduction of cost. Before I tried to reduce the amount of garbage because it was good for the environment and it was the right social norm. Now, it is just 5 cents so why bother? A related change in the perception of the activity has to do with the information regarding the importance of the act (like in the day care study). In scenario 4a I know that it is important to reduce the amount of garbage I produce, but I do not know how important it is. In scenario 4b the authorities tell me that it is 5 cents important. This new information is counterproductive because 5 cents does not seem like a large quantity. Therefore, the reasoning goes, reducing the production of garbage must not be that important. An important aspect of all these examples is that even in cases where incentives have a negative effect on behavior, the effect is only produced by small incentives. Once incentives are introduced, the economic intuition works fine: the more you pay the better. If for each soda can collected the reward was large enough, more people would have collected cans compared with the no-compensation scenario; sex in exchange for money clearly follows the regular supply rules; when the punishment for picking up a child late is high enough, fewer parents will arrive late; if the cost of a disposal bag was 8

9 high enough, people would have reduced the amount of garbage produced. Of course the question of what is a high reward or fine is case- dependent. 3. Experimental design I used 5 variations of a proposer-responder game. 5 In the first stage of each treatment, a proposer decides what portion of $24 she wants to transfer to the responder. The only difference between the five treatments is in the responder s ability to punish or reward at the second stage. I refer to the treatments as: Dictator, Low Punishment, High Punishment, Low Reward and High Reward. In the Dictator treatment the responder can neither punish nor reward. In the Low Punishment treatment the responder can, at a cost of one cent, decrease the proposer s earnings by 1.5 cents. In the High Punishment treatment the responder can, at a cost of one cent, decrease the proposer s earnings by 5 cents. The rewards treatments are the mirror image of the punishment treatments: In the Low Reward treatment the responder can, at a cost of one cent, increase the proposer s earnings by 1.5 cents, and in the High Reward treatment, at the cost of 1 cent, the responder can increase the proposer s earnings by 5 cents. To enable the responder to influence the proposer s payoff, the proposer offer cannot be below $4. The different cost of rewards or punishment is analogous to many real-life situations where the cost versus consequence of rewards and punishments is not one-forone. For example, when an employee decides to sabotage the output of her firm (e.g., by infecting the computer network with a virus), her cost may be very small relative to the 5 The game is a variation of the Andreoni, Harbaugh and Vesterlund (2003) carrot and stick game, where they study the effect of rewards and/or punishment in a recurrent interaction. The main difference between my setup and theirs is that they use only large rewards and punishment (only the 5 factor), and do not use small punishments and rewards. I will compare the two studies later. 9

10 firm s damage. Similarly, a small increase in work effort can cost very little to the employee but have a big positive influence on the firm. The subgame perfect equilibrium under the assumption that players are selfish and care only for their own monetary payoffs is the same for all treatments: the responder, in her turn, will neither reward nor punish the proposer because this would reduce her own payoff. Anticipating this, the proposer will send only the $4 she is required to. Procedure The experiment was conducted at the University of Chicago with 40 proposers and 40 responders in each treatment, totaling 400 participants. In the first stage of the experiment, 200 students who volunteered to participate in the experiment were given instructions for the role of the proposer (see Appendix 1) in which they were told that they would receive $24 for participating. It is important to note that the only difference between the punishment and the reward treatments was the change of one word: decrease versus increase. The choice faced by the proposers was how much out of the $24 received they wished to transfer to the student they were matched with. They could choose any amount between $4 and $24 (the information they received regarding the choice of the responder is described below). That was the only choice made by the proposers in the experiment. They were told that they would be paid, privately and in cash, in the following week after the second part of the study had been run. Identification was made using the students ID numbers. 10

11 At the second stage, a few days later, each proposer was matched with another student (the responder ). The responder received instructions (see Appendix 2) in which he/she was told about the choice made by the proposer in stage 1. This was written with a pen on the instruction sheet. The decision the responder had to make was the treatment manipulation I used. As described above, there were 5 treatments, summarized in Table 1. Treatment Dictator Low Punishment High Punishment Low Reward High Reward Responder s choice None Pay 1 cent for a 1.5-cent decrease in proposer s payoff Pay 1 cent for a 5-cent decrease in proposer s payoff Pay 1 cent for a 1.5-cent increase in proposer s payoff Pay 1 cent for a 5-cent increase in proposer s payoff Table 1: The five experimental treatments Every participant knew all the rules in his/her treatment. The responder did not know the identity of the proposer (it was indicated with a number on his/her instructions), and the responder was not identified to the proposer. 4. Results 4.1 Proposers behavior Appendix 2 reports the transfers of each proposer. Summary statistics are presented in Table 2. 11

12 High Fine Low Fine Dictator Low Reward High Reward Average Standard dev Median Ave. top 20 offers St. dev. top 20 offers $4 proposals 17.5% 50% 32.5% 52.5% 27.5% Table 2: Summary statistics of offers in the different treatments. For each treatment, the equilibrium hypothesis that the average offer is equal to $4 is rejected with p<. 01. This result is not surprising given the literature discussed above. More interestingly, a treatment effect is observed. A nonparametric Mann- Whitney U test based on ranks can be used to investigate whether the sample of proposals came from populations with the same distribution. 6 In Table 2, I report the results of a pairwise comparison of the different treatments. The number in the interaction of row and column indicates, for the corresponding pair of treatments, the probability of getting at least as extreme absolute values of the test statistics as we observe, given that the two samples come from the same distribution. 6 For all the results reported in this paper, using a t-test gives practically the same results in terms of significance levels. 12

13 High Fine Low Fine Dictator Low Reward Low Fine <.001 Dictator Low Reward < **.060* High Reward.268** < <.001 Table 2: (Prob.> t, where t is the test statistic). One asterisk indicates that, for that comparison, we cannot reject the hypothesis that the two samples are from the same distribution at a.95 level of significance. Two asterisks indicate the same for a.9 level of significance. The average offer is highest with High Fine and High Reward, and lowest with Low Fine and Low Reward. The Dictator treatment is in between. Figure 1 presents the average offers. The figure is built such that the proposer s incentives (in terms of punishment or reward) are placed on the horizontal axis, and the choice of transfer on the vertical axis Offers in $ High Fine Low Fine Dictator Low Reward High Reward Treatment Figure 1: Average transfer from proposars to responders. 13

14 Figure 1 demonstrates what I call the W effect of incentives. When rewards or punishments are used, the economic prediction that higher incentives induce higher proposals is supported. However, there is a non-monotonicity close to zero in both the positive and the negative direction. 7 A detailed analysis of the distribution of offers shows interesting differences. The distributions of offers in the five treatments are presented in Figure 2. 7 A possible explanation to the small offers in the Low Fine treatment is that the proposer is afraid of supplying ammunition to the responder. That is, if only $4 are sent, the responder can inflict at most a $6 damage on the proposer. Sending more money can backfire by allowing the responder to damage the proposer more. To test for this explanation, I ran another Low Fine treatment in which both players got a $12 show up fee on top of their earnings as in the original treatment. Responders were allowed to use the extra $12 to punish the proposer. The difference in the results was not statistically significant from the above Low Fine treatment. 14

15 High Fine High Reward Fraction of offers Fraction of offers Offer in $ Offer in $ Low Fine Low Reward Fraction of offers Fraction of offers Offer in $ Offer in $ Dictator Fraction of offers Offer in $ Figure 2: Distribution of offers in the five treatments As can be seen from Figure 2, the modes of the distributions differ between treatments. The most interesting difference is between the High Fine and the High Reward treatments. In the High Fine treatment, most proposers (60%) sent half of the money. It seems as if they wished not to provoke the responders, since responders could 15

16 easily reduce the overall pie, and thus took the safe option. As we shall see later, this choice was indeed the safe choice in terms of the punishment used by responders. In a sharp contrast with this, only 32.5% of the proposers in the High Reward treatment chose to send half of the money. Yet, ten proposers (25%) in the High Reward treatment, as compared with only one (2.5%) proposer in the High Fine treatment, chose to send the entire $24 to the responder. It is interesting to compare these results with Andreoni, Harbaugh and Vesterlund (2003). Their Carrot ( Stick ) treatment, is similar to the High Reward (High Fine) treatment. Yet there are some crucial differences: the pie to be divided was $2.40; players played 10 rounds to become familiar with the task, etc. In the Carrot treatment, Andreoni, Harbaugh and Vesterlund (2003) report that 10% of the proposers sent the entire amount as compared with virtually no transfer of more than half the pie in the Stick treatment. Significantly fewer proposers (10%) transfer half of the pie in the Carrot treatment relative to the Stick treatment (27%). While the percentages are different, the qualitative results of the two studies are strikingly similar. 4.2 Responders behavior As we saw above, proposers did not behave according to the prediction of economic theory based on the assumption of selfishness. Yet, it might be that proposers were still maximizing their own profits predicting the behavior of the responders. That is, it is enough that the responder deviate from the equilibrium by punishing or rewarding proposers in order to change the profit-maximizing behavior of the proposers. The reaction of the responders is presented in Appendix 2. An asymmetry in the design should be noted here: since proposers could not lose money in the experiment, the 16

17 punishment option was bounded from above by $20. The reward option was bounded from above by $120. When responders could punish the proposer, some punishment was observed. For example, in the High Fine treatment, 7 proposers sent the minimal $4 amount. Two (29%) of the responders who got the $4 proposal chose to punish both with a $20 fine. The average punishment was -$4.30, hence the average payment for the proposers who offered $4 was $ In the Low Fine treatment, making high proposals was even less profitable. Four (20%) out of the 20 responders who were offered $4 chose to punish, each with the maximum he/she could ($6, an average punishment of $1.20). Hence, the average profit from proposing $4 was $18.80, much higher than the average profit from offering $12. In the Low Reward treatment, 4 (36%) out of the 11 responders who were offered $12 chose to reward, and the average reward was $1.60. Hence, the proposer lost $6.40 on average by offering $12. In the High Reward treatment, the reaction to a proposal of $12 was an average reward of $8.90 (Six (46%) out of the 13 responders who received this proposal chose to reward). Finally, when proposers sent $24, six (60%) out of the 10 responders chose to reward, and the average reward was $24.50 hence the average profit of the proposer was higher by $4.50 relative to the minimal proposal of $ Total payoffs and shares of the profits Average proposers payoffs are presented in Figure 3. 17

18 22 20 Payoffs in $ High Fine Low Fine Dictator Low Reward High Reward Treatment Figure 3: Average proposers payoff Figure 3 demonstrates a strong treatment effect on proposers payoff. Not surprisingly, allowing the responders to reward the proposer rather than to punish her resulted in an increase in the proposers average payoff. But what about the responders payoffs? Figure 4 presents the averages. 12 Payoffs in $ High Fine Low Fine Dictator Low Reward High Reward Treatment 18

19 Figure 4: Average responders payoff Given the W shape of the proposals graph, it is not surprising that the responders average payoffs also follow a W shape. It is interesting to note that the high average profits of the responders in the High Reward treatment does not come at the expense of the responder. This is demonstrated in Figure 5, in which the joint average payoffs are presented. 34 Joint payoffs in $ High Fine Low Fine Dictator Low Reward High Reward Treatment Figure 5: Average joint payoffs Equity consideration affects participants behavior in many cases (see the Survey in Camerer, 2003). For example, despite the fact that the responders average payoff is highest in the High Reward treatment, her share of the pie is only 34%, compared with a share of 56% in the High Fine treatment. Which distribution would she prefer? The share of the pie of the proposer is presented in Figure 6. 19

20 0.75 Proposers' share $ High Fine Low Fine Dictator Low Reward High Reward Treatment Figure 6: Proposers share of the payoffs It is interesting to note that the Low Reward treatment is worst than the High Reward treatment both on the measure of joint payoffs and equity considerations. However, it is not clear that every proposer would prefer to be in the High Reward treatment over the Low Reward treatment. The reason is the risk associated with each treatment. Figure 7 presents the 90% confidence interval for the proposers payoff. 20

21 60 50 Payoffs in $ High Fine Low Fine Dictator Low Reward High Reward Treatment Figure 7: Average payoffs and 90% confidence interval of the proposers payoffs. 5. The detrimental effect of incentives in the literature and its applications 5.1 Related literature The first demonstrations of the detrimental effect of extrinsic motivation occurred in psychology and economics in the early 1970s. The dynamic in the two literatures since then has been quite different. Psychology: The basic elements of the social psychology approach were set by Deci (1971), who suggested that to understand the effects of extrinsic motivation, one must consider the interpretation ( the functional significance ) that the recipients are likely to have the extrinsic motivation (see also decharms, 1968, and Heider, 1958). Other pioneering papers in this literature were Kruglanski, Alon and Lewis (1972) and Lepper, Greene and Nisbett (1973). An important landmark in the psychology literature was the publication of the book The Hidden Cost of Rewards, edited by Lepper and Greene (1978), which showed that the phenomenon of detrimental effect of extrinsic motivation 21

22 is important and robust to many manipulations. Some theories have evolved as a result of this literature. 8 The discussion around this was re-ignited by Cameron and Pierce (1994) and Eisenberger and Cameron (1996), who, based on a meta-analytical technique, concluded that reward systems should be used, particularly as a motivational strategy in educational settings. Their provocative statements were answered by Deci, Koestner and Ryan (1999) who reviewed 128 different studies from 1971 to 1997, including all the studies considered by Cameron and Pierce (1994). They concluded the opposite, that is, that the data strongly support the phenomena, and that one should avoid using incentives in many cases. The heated controversy resulted in a book ( Intrinsic and Extrinsic Motivation ) edited by Sansone and Harackiewicz (2000), which shows support for the phenomena. Economics: Titmuss (1970) study of blood donation reached conclusions very similar to those of the early psychologists. However, in contrast with the psychology literature, this line of research was not active until the 1990s, during which economists rediscovered the detrimental effect of intrinsic motivation by extrinsic incentives (e.g., Frey, 1994; Frey, Oberholzer-Gee and Eichhenberger, 1996). While social psychology experiments are designed such that incentives are determined by the experimenter and are not part of an interaction between participants, the main focus of the renewed interest in the 8 For example, Deci and Ryan (1980, 1985) formulated the cognitive evaluation theory. The theory assumes that intrinsic motivation is the psychological need for autonomy and competence, such that the effect of rewards depends on how it affects perceived self-determination and competence. Another stream of research in psychology distinguished between the effects of incentives in the short versus the long-run (e.g., Kruglanski, 1978). In line with this literature, Benabou and Tirole (2003) proposed an economic model in which incentives are productive in the short-run, but counterproductive in the long-run. Benabou and Tirole (2003) is a good example that classical economics does not prescribe this effect, and not that classical economics cannot prescribe this effect. Benabou and Tirole (2003) is also a good reference for precise definitions of intrinsic and extrinsic motivation. Another theory by Condry and Chambers (1978, p.66) argues that rewards often distract attention from the process of the activity to the product of getting a reward (see also Kruglanski, Shah, Fishbach, Friedman, Chun, and Sleeth-Keppler, 2002). See Sansone and Harackiewicz (2000) for more psychological theories of this phenomenon. 22

23 detrimental effect of incentives in economics is to try and put it into an economic framework, such as principal-agent relations, legislations and environmental protections. The best survey to date on the economic literature, as well as on what economists can learn from the psychology literature, is Frey and Jegen (2001) (see also the discussion in Nyborg and Rege, 2003). 5.2 Activation of the detrimental effect of incentives in interactive environments I believe that it is instructive for economists to consider the following five categories. In these categories, the introduction of extrinsic incentives influences the interpretation of the interaction in an interactive environment. 1. Information regarding the importance of the task: In many interactions the contract is incomplete. The parents in the daycare study (Gneezy and Rustichini, 2000b) discussed above do not know how bad it is to come late. The contract specified that they should pick their child up by 4pm, but it does not specify the penalty if they do not. The distribution of the parents beliefs regarding how bad it is to be late may include very bad scenarios ( the teacher will make my child suffer ). After the small fine is imposed, the contract is complete in the sense that being late is priced. The low price (small fine) signals to the parents that it is not that bad to be late. Because of that, even after the fine is removed parents are more likely to pick up their child late relative to the control group. This last point is important because once we complete the information that the task is not that important, it is hard to go back. 23

24 2. Insult: In many cases people choose to behave according to social norms. Some of these social norms do not include payment not because it is impossible to include them, but because it is inappropriate to use them. It is insulting to offer your partner money for sex. It might also be insulting to offer payment to those who adhere to social norms, such as not to shirk on the job. Offering people small amounts of money for their time might be insulting because it implies that the side offering the money does not think that their time is very valuable (Gneezy and Rutichini, 2000a). 3. Fairness: In many cases, it is better to ask someone to help you than to tell that person help me or... (See Bohnet, Frey and Huck 2001; Fehr and Gachter, 2002; Schulze and Frank, 2003; Fehr and Rockenbach, 2003; Fehr and List, 2003; Gachter, 2003). 9 Introducing an unfair reward or sanction may destroy altruistic cooperation, and make a small sanction or reward counterproductive. In fact, in some cases even a relatively high sanction can be counterproductive due to spite and punishment (Camerer, 2003). In labor relations, Bewley (1999) reports that managers are aware of the fact that trust is important; their employees should trust them and they should trust their employees. In order to build and maintain such trust, he prescribes that managers should seldom use punishment, because once punishment is used, it may backfire. Employees may shirk, or even sabotage, at work. A similar reaction might evolve towards positive payments. An interesting, and yet unexplored, research question is to discover the importance of the attribution of the sanctions or rewards. 9 The study of Fehr and List (2003) is also interesting because they recruited CEOs for one of their experiments to study the extent to which CEOs use explicit incentives and how they respond to these incentives. They find that for CEO (as well as for students), incentives based on explicit threats to penalize shirking backfire by inducing less trustworthy behavior. 24

25 4. Changing the social norm: from communal to exchange: Voluntary cooperation based on trust, reciprocity and other fairness consideration is of great importance in economic interactions (Kahneman, Knetsch and Thaler, 1986; Sunstein, 1996). One of the central findings regarding social norms of cooperation is that they are very fragile (see the recent survey in Camerer, 2003). Kreps (1997, p.359) asks, Why do people adhere to social norms? and introduces a few possible reasons. 10 He then considers situations in which extrinsic motivation may change the social norm, and hence be counterproductive. In the psychology literature, the differences between economic relationships and social relationships have been studied by Clark and Mills (1979) (see the survey in Aggarwal, 2003). They distinguish between exchange relationships and communal relationships mainly in terms of the norms governing the giving of benefits to the partner. In an exchange relationship, people provide benefits to others in order to receive something in return. In a communal relationship, benefits are given to demonstrate concern for others needs. (For a more elaborate breakdown of types of relationships, see Fiske, 1992.) As Kreps (1997) stressed, introducing monetary payoffs may change the focus of the interaction from communal to exchange. When no extrinsic motivation is present, people focus on the social norm. When external reward is introduced, attention is shifted from the social norm to maximizing profits. 10 The concept of social norms is at the core of sociological theory. An example of a definition is that a norm concerning a specific action exists when the socially defined right to control the action is held not by the actor but by the others. The authority of the others is not voluntarily vested in them, either unilaterally or as a part of an exchange, but is created by the social consensus. (Coleman, 1990, chapters 10 and 11). For an example of the importance of social norms in economics, see Fershtman, Murphy and Weiss (1996), and Lindbeck, Nyberg and Weibull (1999). 25

26 5. Shift from a moral mode to a strategic mode: In the dictator game, the proposer has no strategic considerations; her choice is the only one made in the game. In such a condition, (some) people employ a set of moral rules regarding what is the appropriate behavior (the set of rules I try to teach my daughters to follow). In contrast, in all other treatments, the responder is not just a dummy. The fact that the responder is an active player triggers the proposer to think also about the behavior of the other side. In other words, the introduction of incentives changes the proposers mode of behavior into a strategic or economic mode, in which, for example, the proposer is averse to being a sucker. Note that this is a cognitive explanation regarding the way people react to strategic environment, whereas the communal versus exchange explanation deals with the social aspects of the process. I believe that this type of explanation is most applicable to the results reported in this paper. The above five categories are just a partial list of cases in which incentives might by counterproductive. In some cases, more than one explanation may cause the effect. For example, the daycare data in Gneezy and Rustichini (2000a) can be explained by the new information regarding how bad coming late is, but could also be explained by moving from a communal to an exchange relationship. Before the fine, the social norm is strong, and the relationship is communal; after the introduction of the fine, parents focus on the economic analysis of coming late (a cost-benefit analysis), and the relationship shifts to the exchange mode. These five categories attracted relatively little attention in the psychology literature on the hidden costs of reward. The basic reason is that the psychology literature 26

27 focuses mainly on the individual, and less on a principal-agent type of relationship, or any two party interactions. Another factor missing from the psychology literature is the size of the effect. Economic theory is mainly focused on the positive effect of incentives, while the social psychology literature focuses on the negative effect of incentives. 5.3 Non-monotonicity versus discontinuity I have argued that different considerations may cause the W effect. The W shape implies some form of non-monotonicity in reaction to payoffs. Non-monotonicity is supported, for example, by Kruglanski, Shah, Fishbach, Friedman, Chun, and Sleeth- Keppler (2002), who claim that intrinsic motivation could be conceived of as lying on a continuum of association strength between a goal and an activity. In some cases, however, it is more likely that the effect induces discontinuity at zero as is plotted for example in Figure 3. That is, even the smallest amount of extrinsic motivation can destroy the intrinsic motivation completely. Offers in $ -є є Fines (-) Rewards (+) High Fine Low Fine Dictator 27 Low Reward High Reward

28 Both the non-monotonicity and the discontinuity effect are present in people s behavior, and the question which is affecting behavior (if any) is case dependent. I choose to represent both closely related phenomena by a W shaped behavior. 6. Conclusion The construction of incentive schemes is at the heart of many economic activities. The theory of how incentives work given standard economic assumptions is well developed and understood. Our knowledge about the way real people react to incentives is, in my mind, less developed. In this paper I focus on one aspect of the reaction to incentives: counterproductivity. I show the relation between the size of the incentives and productivity. While the psychology literature focuses on finding the counterproductive effect, economists should be interested in the size of the effect. It is shown that the effect exists for small, but not for large, incentives. Does this mean that economists can disregard the effect as a second-order one? For example, Lazear (2000) studies performance pay and productivity in a large company that, under new management, moved from hourly wages to piece-rate pay. The effects reported are dramatic most importantly, a 44% increase in productivity occurred when the shift in the form of payment took place. Lazear (2000, p.1347) concludes some conclusions are unambiguous. Workers respond to prices just as economic theory predicts. Claims by 28

29 sociologists and others that monetizing incentives may actually reduce output are unambiguously refuted by the data. Not only do the effects back up economic predictions, but the effects are extremely large and precisely in line with theory. My claim is that economic theory and the psychological and sociological findings are applicable to different sizes of payments. The data Lazear (2000) is using deal with substantial amounts of money. The findings in the current paper support this finding: using high payoffs that are contingent on performance result in higher productivity. Yet I do not think that the fact that counterproductivity is observed only for small payments is a good enough reason to disregard it. 11 First, much of economic interaction is about small incentives. McDonald s makes its money on the 99-cent menus; how many times do most of us write a check for $10,000? (See Barron and Erev, 2003, for a discussion of the psychology of small decisions.) Second, the definition of small and large incentives is case-dependent. For instance, people are willing to suffer large losses (as much as a few months of salary) just to punish counterparts who disobey social norms. 12 Third, rewards and punishments are frequently constrained in their size. In the daycare study, for example, principals could not raise the fine to more than $3 because of the norms in this market. Fourth, in many cases payment cannot be contingent on performance. In this case, the employer should be even more careful not to upset the employee. Finally, in order to understand the way incentives work, one should understand the pieces of the psychology of incentives. Treating labor as another factor of 11 A comment I received at one of the seminars I gave on this paper was so, as usual, psychologists are interested in the nickels and dimes while economists are interested in the real thing. 12 For example, Cameron (1999) studied the ultimatum game in Indonesia with stakes as high as three times the monthly expenditure of the average participant. Even with these sizable incentives, results do not uniformly approach the sub-game perfect, selfish outcomes. See also Slonim and Roth (1998) for the effect of learning on punishment and Fehr and Falk (2002) for a general discussion. 29

30 production, like capital, makes one miss important aspects. An interesting discussion of this can be found in Fehr and Falk (2002), in which the psychology of incentives such as reciprocity and fairness is discussed. To understand the psychology of incentives, it is important to see the close connection between the effect of positive incentives and similar effects observed with negative incentives, such as fines and punishments. The reasons for the detrimental effect vary. In the proposer-responder game that was used to demonstrate the phenomena here, I argue that moving from dictator to either a small fine or a small reward changes the mode of behavior from moral to strategic mode. I believe that regardless of the reason for counterproductivity, the W shaped function can be used as a framework. Finally, the findings can contribute to the long-standing debate regarding the use of financial incentives in experiments. The conventional wisdom in experimental economics is that subject should be paid. For example, in the preface for the journal Experimental Economics, Holt and Schram (1998, p.5) state: For most economic issues, it is important to provide subjects with real financial incentives to make careful decisions. Surveys comparing experiments with and without monetary incentives do find differences; most notably, paying subjects reduces the variance in the data (Smith and Walker, 1993; Camerer and Hogarth, 1999; Bonner, Hastie, Sprinkle and Young, 2000; Hertwig and Ortmann, 2001). For example, Harrison and Rutstrom (2003) show that in some cases paying participants even small amounts of money can go a long way. Yet, given the large literature on the potential counterproductive effect of incentives in the laboratory, I believe that some qualifications should be put on the general rule that subjects must be paid. 30

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