CeDEx Seminar - Ofer H. Azar (Ben-Gurion University of the Negev)

Does relative thinking exist in mixed compensation schemes?

Abstract

Several earlier studies have shown that people exhibit "relative thinking": they consider relative price differences even when only absolute price differences are relevant. The article examines whether relative thinking exists when people face mixed compensation schemes that include both fixed and pay-for-performance components. Such compensation schemes are prevalent in many occupations (e.g., salespeople and managers) and therefore are an important practical issue. Surprisingly, the ratio between the pay-for-performance and the fixed compensation does not affect effort, meaning that no relative thinking is found. Another experiment shows that this is not due to reciprocity that cancels out relative thinking. In a third experiment subjects make similar decisions without incentives and the results suggest that the different context (compensation schemes instead of price comparisons) and not the introduction of financial incentives (which were not used in previous studies) is the reason that relative thinking disappears. The results have implications for designing incentive schemes in firms and for designing experiments.

Keywords: compensation schemes; relative thinking; judgment and decision making; pay-for-performance; heuristics and biases.