NBER WORKING PAPER SERIES
PERFORMANCE PAY AND PRODUCTIVITY
Edward P. Lazear
NBER Working Paper 5672
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
July 1996
This research was supported in part by the National Science Foundation and by the National Bureau
of Economic Research. This is a revision of a September, 1995 paper with the same name. I am
indebted to the management at Safelite Glass Corporation for providing the data on which the
empirical analysis is based. Excellent comments by Michael Schwarz and Eric Stout are gratefully
acknowledged. This paper is part of NBER’s research programs in Labor Studies and Productivity.
Any opinions expressed are those of the author and not those of the National Bureau of Economic
Research.
O 1996 by Edward P. Lazear. All rights reserved. Short sections of text, not to exceed two
paragraphs, may be quoted without explicit permission provided that full credit, including @ notice,
is given to the source.
NBER Working Paper 5672
July 1996
PERFORMANCE PAY AND PRODUCTIVITY
ABSTRACT
What happens when a firm switches from paying hourly wages to paying piece rates? The
theory developed below predicts that average productivity rises, that the firm will attract a more able
work force and that the variance in output across individuals at the firm will rise as well. The theory
is tested with data from a large autoglass company that changed compensation structures between
1994 and 1995. All theoretical predictions are borne out. In the firm examined, the productivity
effects are extremely large, amounting to anywhere from about 20% to 36% of output, depending
on what is held constant. About half of the worker-specific increase in productivity is passed on to
workers in the form of higher wages.
Edward P. Lazear
Graduate School of Business
Stanford University
Stanford, CA 94305-5015
and NBER
Many believe that an easy way to increase productivity in an organkation is to pay on the
basis of measured performance. Of course, there are some difficulties associated with performance
pay schemes that have been pointed out in the literature. 1 There have been few attempts to examine
the choice of payment scheme and its effect on output.2 In large part, the lack of literature is a direct
result of a lack of data. It is difficult to fmd situations where some workers are paid on the basis of
performance and other workers are paid according to some other scheme, coupled with the condition
that the comparisons do not *O involve a number of other factors that vary across the groups, The
analysis in this paper does not suffer from the traditional problem. It is based on data from a large
autoglass company named Safelite Glass Corporation. During 1994 and 1995, after the introduction
of new management, the company gradually changed the compensation method for its work force,
moving them from hourly wages to piece rate pay. The effects, which are documented below, were
dramatic and completely in line with economic theory.
In what follows, the theory of piece rate compensation is sketched with particular emphasis
on the predictions that pertain to changes in the compensation method. The theory is backed up by
the empirical results, the most important of which are:
1. A switch to piece rate pay has a sigtilcant effect on average levels of output. This is in
the range of a 36% gain.
‘See Lazear (1986) for a detailed discussion of when to pay a piece rate, which is defined to be payment on the
basis of output, Also, Fama (1991) discusses other reasons for paying on the basis of some measured time interval.
Baker (1992) discusses the difi]culties created by pay-for-performance structures when measurement is a problem. A
very early discussion of the incentive effects of piece rates can be found in Slichter (1928), Ch. 13.
2A notable exception is Brown ( 1992). Some have looked at the effects of compensation in the sports world.
Most recently, Fernie and Metcalf (1996)
find that when payment is contingent on performance, jockeys better
performance than when payment is unrelated to performance. Also, Parsch and Shearer (1996) find that tree planters in
British Columbia produce higher levels of output when paid on piece rate, but that they fatigue more rapidly.
1
2. The gain can k split into two components. More than half of the increase in productivity
results from the average worker producing more because of incentive effects. Some results from a
reduction in turnover among the most productive workers and
workers. None reflects the “Hawthorne effect. ”
3. Productivity gains show up in a number of ways. In
an ability to hire the most productive
addition to an increase in the number
of pieces produced in a given day and altering turnover, moving to pay for performance implies
reductions in absenteeism.
4. The f~m shares the gains in productivity with its workforce. For a given worker, about
half of the worker-specific increased productivity is captured by the worker.
5. Moving to piece rate pay increases the variance in output. More ambitious workers have
less incentive to differentiate themselves when hourly wages are paid than when piece rate pay is
used. Also, the variance in underlying ability rises because the most able workers are attracted by the
piece rate.
The evidence implies that the choice of compensation method is important, not that piece rates
are good. In equilibrium, f~rns choose a compensation method, based on the costs and benefits of
the various schemes. Firms that continue to pay hourly wages must, in equilibrium, fmd that benefits
of paying an hourly wage, such as low monitoring costs and perhaps higher quality output, outweigh
the costs in the form of lower output.
Some conclusions are unambiguous. Workers respond to prices just as economic theory
predicts. Claims by 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.
2
The evidence allows somewhat broader interpretation. It is often difficult to obtain actual
data on consumers and their reactions to changes in prices. Tests of even the most basic tenets of
economic theory are dfilcult to perform, at least at a micro level. These data we well-suited to that
purpose. While expertints bear out the basic response of economic agents to prices, the data used
in this paper come from the real world, rather than a laborato~ setting. Compensation, which reflects
the most important price that a consumer faces, truly matters to the workers in this setting, and they
respond accordingly.
Modeling Choice of Pay Scheme: Hourly Wages versus Piece Rates
The primary motivation behind instituting a piece rate scheme is to increase worker effort.
While it may seem obvious that moving from hourly wages to piece rates would increase effort, it is
not. When a fwm institutes an hourly wage schedule, it usually couples the payment with some
minimum level of output that is acceptable. It is possible, therefore, that the minimum acceptable
output chosen for hourly wage workers exceeds the level of output that workers voluntarily choose
under a piece rate. Further, it maybe that the minimum level chosen under hourly wages is so high
that ordy the most able workers can make the cut. When piece rates are instituted, more
heterogeneityy might be tolerated, resulting in lower average levels of output.
In some sense, the term “performance pay” is not very useful. Even if we restrict performance
pay to refer to pay based on output (rather than input), a broad set of compensation schemes are
included. Hourly wages that are coupled with some minimum standard could be called performance
pay, because a performance standard must be met to retain employment. In fact, were workers
homogeneous, an hourly wage structure with a
minimum number of units tolerated per hour can