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Seoul Journal of Economics
[ Article ]
Seoul Journal of Economics - Vol. 12, No. 1, pp.27-50
ISSN: 1225-0279 (Print)
Print publication date 28 Feb 1999
Received Nov 1998

High-Powered Incentives vs. Low-Powered Incentives: Why Low-Powered Incentives within Firms?

Sonku Kim
Department of Economics, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong skkim@ust.hk

JEL Classifications: D80, J00

Abstract

This paper explains why high-powered incentives are more common than low-powered incentives in market arrangements, while low-powered incentives are more common than high-powered incentives within firms. In a firmlike principal-agent framework in which a common principal participates in the multiple agents’ production processes with his own productive efforts, social efficiency can be obtained by relative performance schemes when the agents are risk-neutral. We derive a group of relative performance schemes which achieve a socially efficient outcome. They are different in their pay-for-performance sensitivity, ranging from a high-powered pricelike relative contract to a seemingly low-powered promotion-based contract. We show that the high-powered relative contract is the most efficient among the first-best relative contracts when the agents have private information, and the promotion-based contract is the most efficient when the agents’ limited liabilities are of serious concern.

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