It is typically argued that paying large bonuses will induce people to exert more effort. This argument is, for example, evoked to justify the large bonuses of managers. Wendelin Schnedler puts forward a theory in which success bonuses actually reduce effort. This may happen even if more effort increases the likelihood of getting the bonus.
The theory is based on the assumption that people are less willing to exert effort when they get richer. In other words, they prefer playing golf, spending time with their family or on their sailing boat instead of sitting in their office. Given this assumption, success bonuses have two effects. On the one hand, there is an incentive effect. Tying a bonus to successful performance means that the manager now has stronger incentives to exert effort. On the other hand, there is an income effect. The bonus means that the manager can expect a larger income - even if she does not increase effort. A larger income, however, means that the manager's willingness to exert effort decreases.
Incentive and income effect need to be weighed against each other. If the manager has relatively little effect on success and the probability of success is high to begin with, the income effect dominates. Then, introducing or increasing bonuses will decrease effort.
The theory has been published in February 2011 under the title "You Don't Always Get What You Pay For: Bonuses, Perceived Income and Effort" in the German Economic Review 12 (1), pages 1-10. Photo: Damien du Toit (creative commons).