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

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.