Ability, career concerns and financial incentives in a multi-task setting

Abstract In a laboratory experiment I investigate the role of perceived own ability in a multi-task setting with career concerns under fixed wages and under financial incentives with a higher weight on the task measured with noise. I find that in the absence of career concerns participants allocate effort evenly between tasks under fixed wages and allocate more effort on the task measured with noise, both irrespective of individual ability levels. However, in presence of career concerns perceived own ability matters for effort allocation. In particular, career concerns distort effort allocation of agents with high perceived ability, whereas agents with low perceived ability show less distorted effort allocation. In the presence of career concerns the interaction between financial incentives and perceived ability is always disordinal, which implies that low ability agents exhibit less distorted behavior under any compensation contract. A higher explicit incentives weight on the task measured with greater noise helps to balance effort allocation, but makes all agents worse off due to strategic behavior of agents. To keep their chances on the labor market high ability agents increase their effort allocation to the precisely measured task slightly in anticipation of a strong focus on the precisely measured task of low ability agents. These findings are in line with economic predictions and show that perceived own ability moderates the relationship between financial incentives and career concerns on effort allocation.

Keywords: ability, career concerns, explicit incentives, implicit incentives, multi-task I gratefully acknowledge comments made by Rick Young (editor), two anonymous reviewers, and Frank Moers.

INTRODUCTION Career concerns are a major source of incentive for many employees (Arya and Mittendorf 2007). An important variable in the context of career concerns is ability. Agents with career concerns try to signal their ability to the labor market in order to gain a better position and increased remuneration in later stages of their career. However, besides several theoretical studies on career concerns (e.g., Holmstrm 1982, Holmstrm 1999, Andersson 2002, Arya and Mittendorf 2007), only few studies examine career concerns empirically (e.g., Gibbons and Murphy 1992, Irlenbusch and Sliwka 2006). Recent working papers in accounting document the relevance of implicit incentives for the design of incentive systems (e.g., Autrey, Dikolli and Newman 2009, Hales and Williamson 2010). However, the role of ability in the context of career concerns and explicit incentives is not examined. The purpose of this study is to examine the role of perceived own ability and explicit financial incentives in a multi-task setting with career concerns. In settings where performance on one task can be measured precisely and on another task with noise, economic theory predicts that a fixed wage is suited best to avoid an effort distortion between tasks due to performance measure characteristics (Holmstrm and Milgrom 1991). This surprising finding obtains because career concerns form implicit incentives for agents that can substitute for explicit incentives. Assuming the labor market favors precise performance measures over noisy performance measures to infer the ability of an agent (Prendergast 2002), an agent with career concerns will focus more on precisely measured tasks, which can be harmful for a firm if this is not in line with firm objectives. To counteract a strong preference of the agent with labor market reputation concerns for the precisely measured task, the principal can increase the incentive weight on a measure with higher noise, as suggested by Prendergast (2002) and Chen and Jiang (2005).

A problem with an increased incentive weight on a difficult to measure task is that it is not an attractive incentive for all agents all the time. Agents are confronted with an allocation decision between a task that is measured with noise but well-paid, and effort on the precisely measured task that is less lucrative but efforts are visible for the labor market. Differences in levels of perceived ability play an essential role for the effect of increased explicit incentives in the presence of career concerns, which is the focus of this paper. The labor market is interested in ability and typically evaluates performance of one agent relative to other agents (Meyer and Vickers 1997). Agents, however, often do not know with certainty their actual ability level relative to other agents, so that strictly speaking perceived own ability rather than actual ability is the primary variable of this study. 1 I argue that ability only matters for effort allocation in the presence of career concerns. Under fixed wages and in presence of career concerns, agents with high ability can always outperform agents with low ability so that for agents with low ability career concerns become irrelevant. As a consequence, I predict that agents who perceive their ability to be high focus more on the precisely measured task whereas agents with low perceived ability act as if career concerns were absent. Explicit incentives that are used to balance incentives of career concerns also have a very different effect on effort allocation, depending on the ability level of an agent. I predict that as long as the incentive weight on the difficult to measure task is higher than on the task measured precisely, agents with high perceived ability will focus more on the task measured with noise than agents with low perceived ability. I use a laboratory experiment to examine the role of ability and explicit incentives in a multi-task setting with career concerns. I manipulate the absence and presence of a labor market

Agents might believe that they have more (less) ability than it is actually the case and react to explicit and implicit incentives accordingly (Chen 2009).

where principals can attract and hire new agents in order to evoke career concerns. Two types of compensation (fixed wages and unequally weighted financial incentives, financial incentives hereafter)2 are the between-subjects factor and perceived own ability is a within-subjects factor. In multiple periods participants work on two decoding tasks per experimental period. Performance on the two tasks is equally sensitive to the ability of participants. Performance on one task is measured precisely and performance on the other one is measured with noise. An equal effort allocation maximizes the payoff of the principal. After each period, principals evaluate the performance of the agents on two tasks with one performance measure each: a precise measure of one task, and a noisy measure of the other task. Principals compete with each other for agents by offering agents a temporary wage increase. Agents are automatically assigned in the subsequent period to the principal offering the highest wage for that subsequent period. In the case of equal offers from the two principals, the agent remains with his original assignment. Results are generally in line with economic theory. In the absence of career concerns participants allocate effort evenly between tasks under fixed wages and allocate more effort on the difficult to measure task that is rewarded higher under financial incentives, both irrespective of individual ability levels. Perceived own ability only matters for effort allocation in the presence of career concerns and actually moderates the effect of financial incentives on effort allocation. Specifically, under fixed wages participants with high perceived ability focus in their effort allocation on the precisely measured task, whereas participants with low perceived ability allocate their efforts as if a labor market was absent. The economic reason here is that participants with high perceived ability can easily outperform participants with low perceived

Unequally weighted financial incentives have a higher weight on the noisy measure, and a reduced weight on the precise measure. I ignore financial incentives with equal weights on both tasks, because due to an additive noise term with a mean of zero the optimal response of the agent to this incentive scheme in the presence of a labor market would theoretically be the same as under fixed wages.

ability, so that career concerns are practically irrelevant for participants with low perceived ability. Further, effort allocation under fixed wages is costless for the agent. Under financial incentives and in the presence of career concerns, behavior of participants becomes strategic. Whereas in the absence of career concerns all participants focus on the task measured with noise with higher rewards, career concerns lead participants with low perceived ability to shift their allocation toward the precisely measured task. For those agents an increased effort allocation on Task A increases the chances of gaining from the labor market. In anticipation, agents with high perceived ability slightly increase the effort allocated to Task A in order to keep the chances of gaining from the labor market high. The shift of effort allocation to the precisely measured task is costly for both agents with high and low perceived ability, because output on the precise task is rewarded less than output on the task measured with noise. Both types of participants are thus worse off compared to a setting without career concerns. The findings of this study demonstrate the complex interplay between explicit incentives, implicit incentives in form of career concerns and perceived ability. Career concerns distort effort allocation of agents with high perceived ability, whereas agents with low perceived ability show less distorted effort allocation in the presence of career concerns. As the interaction between financial incentives and perceived ability is in presence of career concerns is disordinal, low ability agents show less distorting behavior under either compensation contract.3 Higher explicit incentives on the task measured with noise help to balance effort allocation (see also Chen and Jiang 2005). However, this solutionmakes both agents with high and with low perceived own ability worse off.

A less distorting effort allocation is not necessarily preferred by the principal, as shown by Brggen and Moers (2007, Appendix).

The remainder of this paper is organized as follows: In the next section, I develop my hypotheses derived from economic theory. The experimental design is described in the third section, and results are presented in section thereafter. The final section discusses the findings and concludes this study.

THEORY AND HYPOTHESIS Career concerns describe the concern that current performance has an impact on compensation in later periods. This is a form of an implicit incentive (Gibbons and Murphy 1992; Andersson 2002; Holmstrm 1999; Prendergast, 1999). Based on career concerns, agents choose their effort in such a way to gain an improved reputation in a labor market (Irlenbusch and Sliwka 2006; Koch, Morgenstern, and Raab 2006). Meyer and Vickers (1997) find that career concerns are strongest when noise in a performance measure is low and the labor market can infer the ability of an agent. Similarly, Prendergast (2002) suggests that career concerns diminish with increasing levels of noise in a performance measure or increasing uncertainty in the environment. An aspect that is largely ignored in studies on career concerns is the role of individual ability. Ability is an essential criterion for the labor market and consequently, individuals have an interest to show high ability to the labor market. Following the assumption that a labor market favors a precise performance measure over an imprecise one, career concerns can induce a preference of agents to deliver more effort on the precisely measured task. More specifically, agents working on multiple tasks can signal the labor market high ability by allocating effort on tasks and performance measures that are visible to the labor market (Autrey, Dikolli, and Newman, 2006). Koch, Morgenstern and Raab (2006) find that career concerns in multi-task

settings can induce agents to make a performance signal look even more favorable than it actually is which is harmful for both the current and possible future employer. In a multi-task setting with two tasks, Task A and Task B, economic theory can explain why career concerns can lead to different reactions by agents depending on differences in perceived own ability. Let total effort E of agents be composed of effort on two tasks, eA and eB. The output of an agent is measured by two performance measures: A= B= where eA eB +

is the individual ability level of an agent and is the error term with mean zero that

makes measurement of performance on Task B noisy. Ability levels can be either low ( L) or high (
H)

with

H.

Effort allocation of agents is given by

If agents of high and low ability allocate a given

total effort level E in the same way between the tasks, then this implies
L

eA < eB <

eA eB

AL < AH E[BL] < E[BH] , high ability agents outperform

That is, at the same level of total effort E and allocation

(in expectation) low ability agents on both performance measures.

Fixed wages

For reasons of simplicity, the model does not formally incorporate uncertainty of the agents about their own ability. However, insights of the model hold for some degree of uncertainty in the sense that the agents do not need perfect knowledge about their ability type but a sufficiently precise believe (perception).

In absence of career concerns and presence of fixed wages, the payoff given by =W

of the agents is

In this case, agents receive a fixed wage (W) irrespective of their level of effort or effort allocation. As a result, agents do not have any economic incentive to deviate from the principal s preferred effort allocation. This implies that and
L

for both low and high ability agents

eA <

eA (

eB <

eB).5

PREDICTION 1: Under fixed wages and in absence of career concerns, agents allocate effort evenly between tasks, irrespective of ability level.

Financial incentives In the presence of financial incentives on both performance measures, the payoff for agents is given by:

AA

BB

where

is the explicit incentive weight. In this setting, the effort allocation is driven by the
A

difference in incentive weights. Under the assumption that, for example,

<

, agents shift

their effort to Task B, because the explicit incentive for performance on that task is higher. The contract provides an incentive for this effort allocation irrespective of ability levels, which implies that is the same for both low and high ability agents and eA < eB.

This holds according to economic theory unless agents follow a random strategy.

PREDICTION 2: Under financial incentives and in absence of career concerns, agents will allocate more effort to the task that is rewarded more, irrespective of ability level. Fixed wages and career concerns The presence of career concerns, however, has different influences on the effort allocation of agents with low and high ability and depends on the compensation contract to which they are exposed. Under the assumption that the labor market focuses on the precise performance measure A to assess the ability of agents, the implicit incentives can be described as a probability of gaining a wage increase that depends on A: Prob ( | A) The payoff for agents in a setting with fixed wages is then described by

= W + Prob ( | A) In isolation, all agents would like to increase their effort on Task A to gain a wage increase, given that effort allocation is costless to the agents in a setting with fixed wages. However, once agents with high ability focus their effort on the precisely measured Task A, agents with low ability cannot gain from career concerns, because agents with high ability always outperform them, given that for any given effort level eA,
L

eA <

eA. As a result, agents who perceive

their ability to be low do not consider career concerns as an implicit incentive and allocate their effort similar to the setting with only fixed wages. Agents who perceive their ability to be high will allocate more effort to Task A.

PREDICTION 3a: Under fixed wages and in presence of career concerns, agents with low perceived ability allocate effort evenly between tasks and follow the principal s objective.

PREDICTION 3b: Under fixed wages and in presence of career concerns, agents with high perceived ability allocate less (more) effort to Task B (Task A) than agents with low perceived ability.

Financial incentives and career concerns In a multi-task setting and in presence of career concerns, the effort allocation of agents with high ability can thus be distorted once fixed wages are provided. These agents focus on precise performance measures in order to be able to signal their ability to the labor market, which can cause problems in firms where agents work in multi-task settings and performance on tasks is measured with varying levels of precision. Firms require not only high levels of effort, but also an effort allocation that is in line with the overall organizational objectives (Indjejikian 1999). Chen and Jiang (2005) also examine the role of career concerns in a multi-task setting. They provide a solution to the problem that in multi-task settings agents with career concerns shift their effort to the precisely measured task that functions as a signal to the labor market. To avoid a possibly harmful effort allocation for the firm the authors suggest an increase in the explicit incentive weight on the task measured with noise in order to balance incentives due to career concerns. In the presence of career concerns and financial incentives with a higher weight on Task B, the payoff for agents is given by: =
AA

BB

+ Prob ( |A)

with

<

In this case, the behavior of agents becomes strategic. Agents with high ability have initially no incentive to change their effort allocation compared to the setting of financial incentives without

10

career concerns. The reason for this is that they already outperform low ability agents and can thus gain the wage increase offered by the labor market. Given a lack of response by the high ability agents, the agents with low ability see an opportunity to increase their changes on the labor market by increasing the effort allocation to Task A. However, in expectancy of this strategic move by agents with low ability, agents with high ability will slightly increase their effort on Task A so as to make sure that they do not lose their chances on the labor market. This will make the increased effort allocation to Task A by agents with low ability fruitless. In essence, both types of agents are worse off because both give up performance on Task B, which is higher paid (
A

<

B),

without any additional gains compared to the status quo.

Despite this, the strategic nature of this setting makes these responses rational responses and as such an equilibrium. 6

PREDICTION 4a: Under financial incentives and in presence of career concerns all agents allocate less (more) effort to Task B (Task A) than under financial incentives and in absence of career concerns. PREDICTION 4b: Under financial incentives and in presence of career concerns, agents with high perceived ability allocate more (less) effort to Task B (Task A) than agents with low perceived ability.

EXPERIMENTAL METHOD Experimental procedure and task

From the agents perspective, the setting here is similar to a prisoner s dilemma problem. Both types of agents are better off bonding and not reallocating their effort compared to a setting where there is no labor market. However, in the absence of an opportunity to credibly bond, which is assumed here, the strategic interaction pushes the agents to engage in costly activities with no benefits.

11

I test my predictions in an experiment with 75 business students. I conduct a laboratory experiment where I manipulate two types of compensation schemes (fixed versus financial incentives) and the presence of career concerns as between-subjects factor and perceived ability as a within-subjects factor. The 75 students are randomly assigned to the treatments. In the career concerns treatments there are two different roles, the role denoted as agent and the role denoted as principal.7 Roles are randomly assigned and stay the same throughout the whole experiment. The experimental task is a simple decoding task, which is similar to studies by Chow (1983), Shields and Waller (1988), Chow, Cooper, and Waller (1988), Sillamaa (1999), Fisher, Peffer, Maines, and Sprinkle (2002), and Stevens (2002). There are different decoding schemes for each task, but both Task A and Task B do not differ in complexity. However, similar to the experimental setting of Fehr and Schmidt (2004), performance on Task A is measured precisely and performance on Task B is difficult to verify due to noise. Agents are informed that an even effort allocation is most desirable for the principals, because this maximizes their payoff. Based on two pilot tests I derive performance standards on which the compensation schemes are developed and to determine the parameters used in this experiment. The experiment starts with a training session to familiarize agents with the experimental task. After this, five experimental periods of two minutes each follow. 8 Participants are informed when 60 seconds and when 10 seconds are left in a period. Performance is measured as follows: result Task A: rA = 30 + amount of correctly decoded numbers of Task A; result Task B: rB = 30 + amount of correctly decoded numbers of Task B + e.
7

Roles were neutrally described in the instructions as either X-player, Y-player, or Z-player to reduce the influence of uncontrollable connotations. For reasons of clarity, I denoted the role of X-player as agent, and the roles of Yand Z-players, who had the role of a labor market in search of a certain talent, hereafter as principal. Except for information on the labor market, all information is the same also for participants in the no career concerns treatments, so for reasons of simplicity - I refer to them also as agents. 8 I restrict the experiment to five periods (excluding the training session) due to time restrictions. The experiment lasts about one hour.

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At the beginning of each period, agents receive 30 points.9 Per correctly decoded number of Tasks A and B, they receive one additional point. Whereas performance for Task A is measured precisely, performance on Task B is measured imprecisely. The performance measure on Task B includes a random number e between 20 and 20 (uniformly distributed) that is added to the amount of correctly decoded numbers of B.10 This means, that the actual decoding abilitycannot be assessed precisely on rB, the measure for Task B. How performance on the two tasks is measured is known to all participants of the experiment. I perform pilot tests to practice the procedures of the experiment, and to test the manipulations and instructions. Figure 1 provides a graphical overview on the experimental procedure. Figure 1 about here To assure that all participants understand what their task is, the experiment does not start until all participants understand the examples in the instructions.

Compensation There are two different compensation schemes. In the fixed wage treatments, agents are paid 2 per period irrespective of their performance. In the financial incentives treatment, incentive weights on the two performance measures differ.11 I specify the incentive weight on the noisy performance measure as 0.08 per point above 30 of rB, and on the precisely measured task as 0.04 per point above 30 of rA. This is a simplified way of specifying incentive weights, but serves the purpose of this study, i.e., to investigate the effort allocation of agents when the

I choose 30 to avoid negative numbers or a zero. A negative number or a zero can lead to a biased judgment and may even distort performance evaluation. All values larger than 20 also serve this purpose, but 30 is a more convenient number and leads to two-digit numbers as results. Performance measurement is the same also for the treatments without career concerns. 10 This noise term is additive with a mean of zero, which is in line with most of the economic literature. 11 I ignore financial incentives with equal weights, see footnote 2.

13

incentive on the noisy performance measure is higher than on the precise measure. To keep the experimental procedures as simple as possible and to keep the level of internal validity high the compensation schemes remains throughout the experiment, i.e., the incentive weights and the level of compensation remains constant within each treatment. Compensation of agents in the two different compensation treatments is thus specified as follows:

Compensation agents fixed wage Compensation agents financial incentives

= 2per period = (rA 30) 0.04 + (rB 30) 0.08

Perceived own ability Perceived own ability is a measured independent variable. Participants are asked to respond on a 7-point Likert scale anchored by strongly disagree and strongly agree to statements measuring personality traits. Two items measure the level of perceived own ability. In particular, participants respond to the statements I think I am pretty good at the experimental tasksafter period 1 and I am pretty skilled at the experimental task.after period 3. The questionnaire items are presented in five different short questionnaires that are handed out to participants of the experiment after every period. The final questionnaire is the exit questionnaire and includes demographic questions as well as manipulation checks with respect to the compensation schemes and the career concerns manipulation.

Career concerns To simulate career concerns, it is necessary that there is a labor market interested in skilled agents. I assign at random roles of principal to participants who act as a labor market.

14

Agents and principals form markets. There are two principals per market who compete with each other for skilled agents. In the first period, agents of a market are equally divided between the two principals. To achieve an equal division of agents, the number of agents per market must be an even number. There are eight to ten agents in a market so that the number of agents does not get too large. After every period, the principals receive a list with the performance measures rA and rB of each agent listed by their experimental ID. Principals are compensated based on the performance of agents that are assigned to them. Principals have the possibility to attract (or keep) agents from each other by making an additional wage offer of either 0 , 1 , or 2after each period. They first make an offer to the agents that are assigned to the other principals in the previous period and after that a counter offerto the agents that are assigned to them in the previous period. After the initial offer and the counter offer are made, agents are assigned in a subsequent period to the principal who made the highest offer. In a case of equal offers for one agent, the agent stays assigned to the principal of the previous period. The wage offer that was the winningbid is added to the compensation of the agent in the next period, and deducted from the welfare of the bidding principal. This induces the principal to compete for agents with high decoding skills. A principal is compensated per assigned agent based on the following formula: CompensationPrincipal = (0.1 (rA 30) 0.1 (rB 30)) 0.40 bonus wage. The actual amount of numbers decoded by an agent is not revealed to the labor market and remains the private information of the agent.

Dependent variable

15

Due to the simplicity of the tasks, I consider the amount of correctly decoded numbers as a sufficient proxy for effort, and the amount of decoded numbers of Task B relative to the sum of decoded numbers of Task A and Task B as a proxy for effort allocation.

RESULTS Descriptive statistics In the treatment with career concerns there are 34 participants with the role of agent, and eight participants act as principals. In the treatment without career concerns there are 15 participants in the treatment of fixed wages and 18 participants in the treatment of financial incentives. Analysis reveals that there is no gender effect in this study. Agents decode on average 43.9 numbers (both tasks together) per period with no statistically significant difference between treatments. Even in the treatment without any total performance incentives (fixed wages and no career concerns) total effort is not significantly different from total effort in other treatments. This seems to be in contrast with the assumption of effort aversion in economic theory, and it appears that participants prefer delivering effort over doing nothing. I argue that the fact that participants could not leave during the experiment (and choose leisureinstead of work ) is the main reason for this finding. On average, agents earned 11.86 during the experiment. Principals earned on average 6.36.12 Table 1 about here Per agent, mean wage offers range from 1.47 after period 1 to 1.06 after period 4. There is no statistically significant difference of wage offers between periods. Between
12

The relatively low mean compensation for principals is mainly due to one principal making high bonus offers for the last period that were all successful, so that the relevant principal also had to bear the compensation costs that were not made up by the performance of the assigned agents to him. The median of principal compensation was 7.26.

16

treatments, mean offers of principals are 1.17 in the fixed wage treatment and 1.25 in the financial incentives treatment. The situation that a agent gets assigned to a different principal in a subsequent period (switch) occurs 17 times. Switches strongly decrease from period to period with 9 switches after period 1, 3 switches after period 2, 4 switches after period 3, and only 1 switch after period 4. The mean of participants responses to the two items that measure perceived own ability is 4.28 (standard deviation=1.01) for the statement I am pretty skilled at the experimental task. , and 4.34 (standard deviation=1.04) for the statement I think I am pretty good at the experimental task. , both statements on a 7-point Likert scale with 1=strongly disagree and 7=strongly agree. Answers to both items strongly correlate with each other ( =0.57, p<0.01), which indicates that perception of own ability over time does not differ much. Further, the combined measure of perceived own ability (mean=4.31, standard deviation=0.91) strongly correlates with actual total output ( =0.50, p<0.01). For the analysis I use the combined measure, i.e., the mean responses of participants to both statements. However, results are not different in quality with each of the responses to the two statements individually.

Manipulation Checks All participants answer the question in the exit questionnaire with respect to their compensation treatment correctly. Participants had to indicate whether their compensation was fixed or performance-based. I therefore conclude that all participants understand their relevant compensation. Participants in the relevant treatment groups also understand the role of the different players in the experiment and also understand that agents can implicitly increase their

17

compensation if the labor market makes them a bonus offer based on the two performance measures.13

Analysis Figure 2 shows the effort allocation to Task B of participants in absence (Panel A) and in presence (Panel B) of career concerns. To classify high versus low perceived ability I specify a dummy variable DAbility for ability that equals 1 for high ability and zero for low ability, based on a median split of the measured variable Ability (median=4.5). Ability is the mean of participants responses to two questionnaire items that measure perceived own ability as specified earlier. Figure 2 here First, I test H1 and H2 that predict that effort allocation is not affected by perceived own ability under fixed wages and under financial incentives in absence of career concerns. I use repeated measure analysis of variance (ANOVA) on effort allocated to Task B, where Dincentives is a dummy variable that equals one if the treatment is a financial incentive treatment and zero for fixed wages and Ability is as specified earlier. Results are shown in Panel A of Table 2. The main effects of DIncentives and Ability are both significant (F=11.83, p<0.01, and F=2.53, p<0.05, respectively) whereas the interaction of the two variables is insignificant (F=0.12, p>0.50). I use contrast coding to test the relationship in Panel A of Table 2 further, and use DAbility to classify participants in addition to the experimental treatment. In line with H1 and H2 contrast codes are specified as -1, -1, 1 and 1 for the treatments Fixed Wages/Low Ability, Fixed Wages/High Ability, Incentives/Low Ability, and Incentives/High Ability, respectively. The result of the contrast analysis is highly significant (F=15.18, p<0.01), so that H1 and H2 are both supported.

13

In this manipulation check participants had to verify the statement: During the experiment Y- and Z-players evaluated me and could make wage offers to me.

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Additional t-tests show that in absence of career concerns participants under fixed wages do not differ significantly from an effort allocation of 50%, the one desired by the principal (participants with low ability t=0.22, p>0.50; participants with high ability t=-1.65, p>0.10). H 3a predicts that in presence of career concerns agents with low ability allocate effort evenly between tasks and follow the principal s objective. The mean effort allocation of agents with low perceived ability (D Ability =0) on Task B is 43 percent. Results of a t-test (t=-0.61, p>0.50, not tabulated) show that there is no significant difference to the desired effort allocation of 50 percent per task, so that H3a can be supported. H3b and H4b predict a disordinal interaction between financial incentives and ability in presence of career concerns. Panel B of Table 2 shows repeated measure ANOVA results on effort allocated to Task B in presence of career concerns. As bonus decisions of the labor market of the past period can have an influence on the behavior of participants in the current period, I include the labor market bonus paid based on performance in the previous period as factor, labeled Bonusprevious period. As the labor market starts paying bonuses after the first period, values of that variable are set to zero for the first period. The main effects of DIncentives and Ability are both significant (F=5.22, p<0.05, and F=7.05, p<0.01, respectively). The interaction of the two variables is highly significant (F=15.11, p<0.01), which is first evidence for H3b and H4b. Again, I use contrast coding to test this relationship on effort allocated to Task B further. Using DAbility for classification in addition to the experimental treatments, I specify contrast codes in line with H3b and H4b as 0, -1, 0 and 1 for the treatments Fixed Wages/Low Perceived Ability, Fixed Wages/High Perceived Ability, Incentives/Low Perceived Ability, and Incentives/High Perceived Ability, respectively,. The result of the contrast analysis is highly significant (F=38.51, p<0.01) and supports H3b and H4b.

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Further, H4a predicts that under financial incentives all agents allocate less effort to Task B in presence of career concerns than in absence thereof. The mean effort allocation to Task B is 50 percent in presence of career concerns and 76 percent in absence. The difference is significant (t=3.27, p<0.01, not tabulated), so that H4a is supported. The main objective of this paper is to examine whether individual ability moderates the effect of financial incentives and career concerns on effort allocation. In addition to the above analysis, I test the following model with a repeated measure analysis over periods 1-4. EffortTask B = + +
0+ 1 DIncentives + 2 Dcareer concerns + 3

Ability +

4 DIncentives

Dcareer concerns

5 DIncentives 7 DIncentives

Ability +

6 Dcareer concerns Ability

Dcareer concerns Ability +

(1)

where Dcareer concerns is a dummy variable that equals one if the treatment is a career concerns treatment and zero otherwise. All other variables are specified as earlier. Results of the model are reported in Table 3. The three-way interaction between incentives, ability and career concerns is significant ( 7=0.18, p<0.05), which is further evidence that financial incentives have a significantly different effect on the relationship between career concerns and effort allocation, depending levels of perceived own ability.

Table 3 about here

Supplementary analysis of the labor market During the experiment the principals first made an initial wage offer to those agents who were assigned to the other principal. After that, principals had the opportunity to make counter

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offers to keep certain agents. In order to keep an agent, the counter offer must at least be equal to the initial offer. In order to get an agent from the other principal, the initial offer must be higher than the counter offer. There are no switching costs. Agents were informed about the winning offer. Whereas the initial offer was mainly determined by the performance measures of each agent, rA and rB, the counter offer depended also on the initial offer. Based on this process I first analyze the initial wage offers and after that the changes in additional wages of the agents. To analyze the initial wage offers, I use an ordered-probit analysis to test the following model:

FIRSTOFFER =

1 rA

2 rB

DFW +

1,

(2)

where FIRSTOFFER is the initial additional wage offered to an agent by the other principal after each period, rA is the precise performance measure of each agent, and rB is the noisy measure of each agent.14 The variable DFW is a dummy variable that equals one for the fixed wage treatment and zero otherwise. The intercept reflects the treatment with financial incentives. Results are shown in table 4 over all periods and per period as a wage offer after each period. The coefficient for
1

is positive and significant at the 1 percent level for all periods (

2

1=

0.04, t = 5.15). The coefficient for periods (

2=

is also positive and significant at the 1 percent level over all

1

0.02, t = 3.56). The coefficient of

1

is larger than the coefficient of

and the

difference between

and

is significant at the 1 percent level over all periods (t = 3.43). These

results indicate that the labor market puts a higher weight on the precise signal than on the noisy one. The better the performance of an agent with respect to the precise signal, the higher the first
14

This offer is the first offer after a period where the offer of the other employer is not known. Counter offers are left out of the analysis of H1, because the counter offer is not only determined by the performance measures, but also by the wage offer of the other principal.

21

additional wage offer for that particular agent. The independent variables rA and rB are correlated with each other ( rA,rB = -0.51, p < 0.01). The variance inflation factor of the two variables is less than two, which indicates that multi-collinearity is less of a concern in the analyses including these two variables.15 Table 4 about here Furthermore, I analyze the net effectof changes in additional wage for the agent. These changes constitute the final result of the evaluation of the labor market that is communicated to the agents and is therefore important to examine. Agents are informed only about the additional wage that they received, but had no influence on who of the principals was hiring (and paying) them. To examine the actual change in additional wages of agents, I test the following model:

WAGECHANGE =

1 rA

2 rB

DFW +

3,

(3)

where WAGECHANGE is the maximum of either the first offer or the counter offer, i.e., the winningoffer. All other variables are specified as in Model (2). I present the results of an ordered-probit analysis for Model (3) in table 4. Over all periods, the coefficient for and larger than the coefficient for level (
1= 2. 1

is positive

Both coefficients are strongly significant at the 1 percent

0.03, t = 4.38;

2=

0.02, t = 2.99), suggesting that both performance measures are

1

considered for evaluation purposes, but a significant difference at the 1 percent level between and
2

(t = 2.99) indicates that the precise performance measure for Task A is considered more

than the performance measure of Task B.16

15 16

A Durban-Watson test indicates that there is no autocorrelation (DW=1.77). Results are not significantly influenced by autocorrelation (DW=1.74).

22

These results are confirmed in a per-period analysis, where the coefficient for larger than the coefficient for
2.

is equal or

Table 5 about here

DISCUSSION AND CONCLUSION The purpose of this study is to investigate the role of ability on the relationship between explicit financial incentives and career concerns as implicit incentives on effort allocation in a multi-task setting. I use a simple laboratory experiment where I manipulate the absence or presence of a labor market to induce career concerns and the design of explicit incentives (fixed wages versus performance-based incentives with a higher weight on the task measured with noise). Perceived own ability is a measured within-subjects variable. Based on economic theory and the assumption that a labor market favors precise performance measures to assess ability of individuals I derive 6 hypotheses that relate to effort allocation of agents in multi-task settings. Perceived ability is only relevant for effort allocation when career concerns are present. In absence of such concerns, agents follow objectives of the principal under fixed wages or follow the explicit incentives given for the tasks, i.e., more effort on tasks that are rewarded with higher incentives. In presence of career concerns and under fixed wages, however, agents with high perceived ability shift their effort to the precisely measured task to gain benefits from the labor market. For agents with low perceived ability, however, career concerns are not necessarily an incentive because they know that agents with high ability can easily outperform them in their effort on the precisely measured task because effort allocation is under fixed wages costless and their output is expected to be higher than output of agents with low ability. Under financial incentives and career concerns, however, agents with low perceived ability shift their focus to the 23

precisely measured task in order to gain from the labor market. In expectancy of this move, high ability agents need to only slightly increase their relative effort to the precisely measured task so that they in absolute output on this task- still can gain from the labor market. This move, however, is costly because performance on the task measured with noise is compensated more than performance on the task measured precisely. Findings of this study demonstrate the complex interplay between explicit incentives, implicit incentives in form of career concerns and ability. Different incentive weights can help to align interest of agents and principal in presence of implicit incentives as shown by Chen and Jiang (2005). However, ability moderates the effectiveness of different incentive weights on effort allocation of agents. There is increasing evidence on the implicit incentive mechanisms of career concerns in the literature. Characteristics of performance measure properties are important for effort allocation decisions in multi-task settings, and problems with different levels of performance measure quality in such setting can be solved by incentive mechanisms or the use of fixed wages (Holmstrm and Milgrom 1991). The presence of implicit incentives in form of career concerns, however, adds to the complexity of incentive design. Explicit incentives can be one way to counter an undesired effort allocation due to career concerns. An important aspect in context of explicit incentives and career concerns is individual ability. Results of this study add to our understanding of ability and underline the difficulty of the interplay of ability and explicit and implicit incentives in multi-task settings. Findings of this study have implications for theory and managerial practice. Whereas the previous literature suggests that an increased explicit incentive weight one a task measured with noise helps to reduce the implicit incentives due to career concerns (Cheng and Jiang 2005), this study examines in addition the role of perceived ability as an important variable for the influence of career concerns. Given the fact that ability, and in

24

particular perceived own ability, is different across employees and that career concerns are an important incentive mechanism, the combination of ability, implicit and explicit incentives is important in order to improve the design of incentive schemes. Results also imply that the presence of a labor market has implications for an internal incentive scheme of a firm. Compensation needs to take these implicit incentives into account and needs to serve not only on motivating effort but in addition, motivate agents to stay with the firm. This study is subject to limitations. In designing the experiment certain parameters were chosen. As with all laboratory experiment, these parameters influence the results, but it is unlikely that different parameters would significantly change the findings and alter the conclusions of this study. The independent variable Ability is a measured variable that captures perceived own ability of participants. Given the fact that this variable is measured and not randomly assigned, correlated omitted variable problems cannot be ruled out entirely. If participants were fully aware of their actual ability relative to others, actual ability should lead to similar results. However, the design of the experiment and the noise in the performance measure for Task B make it difficult for agents to assess their actual ability relative to other participants so that perceived ability is a better measure. Further, the experiment is a very simplified labor market without switching costs and communication between subjects was not possible. Also, the compensation contracts are determined exogenously in order to analyze the effects of it. In managerial practice such contracts and changes to such contracts could be the response to certain behavior of agents. For simplicity, I determine the contracts without the option for the principals in the experiment to change. Future research might address these limitations. Allowing different forms of group dynamics and communication between participants in an experiment could be an interesting

25

avenue for future research. Reputation and social status are influenced by careers, and future research could include such components of career concerns. Further, future research could investigate further the role of implicit incentives. In this study, agents were not informed about the performance of their fellow agents. This condition could be changed in another setting. Knowledge of the performance of colleagues can lead to more strategic behavior based on the bonus payments. Future research could also investigate a combination of implicit incentives due to career concerns and implicit incentives related to future performance benchmarks.

26

REFERENCES Andersson, F. 2002. Career concerns, contracts and effort distortions. Journal of Labor Economics (20): 42 58. Arya, A., and B. Mittendorf. 2007. The benefits of aggregation in the provision of career inventives. Working paper. Autrey, R. L., S. S. Dikolli, and P. Newman. 2006. The effect of career concerns on the contracting use of public and private performance measures. Working paper, Harvard Business School. Autrey, R. L., S. S. Dikolli, and P. Newman. 2009. Career concerns and mandated disclosure. Working paper, Harvard Business School. Brggen, A., and F. Moers. 2007. The role of financial incentives and social incentives in multitask settings. Journal of Management Accounting Research (19): 25-50. Chen, Y. 2009. Career concerns, project choice, and signaling. Working paper, Arizona State University. Chen, Q., and W. Jiang. 2005. Career concerns and the optimal pay-for-performance sensitivity. Working paper, Duke University. Chow, C. 1983. The effects of job standard tightness and compensation scheme on performance: An exploration of linkages. The Accounting Review (58): 667 685. Chow, C., J. Cooper, and W. Waller. 1988. Participative budgeting: Effects of a truth-inducing pay scheme and information asymmetry on slack and performance. The Accounting Review (63): 111 122. Fehr, E., and K. M. Schmidt. 2004. Fairness and incentives in a multi-task principal-agent model. Scandinavian Journal of Economics (106): 453 475.

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Fisher, J., L. Maines, S. Peffer, and G. Sprinkle. 2002. Using budgets for performance evaluation: Effects of resource allocation and horizontal information asymmetry on budget proposals, budget slack, and performance. The Accounting Review (77): 847 865. Gibbons, R., and K. Murphy. 1992. Optimal incentive contracts in the presence of career concerns: Theory and evidence. Journal of Political Economy (100): 468505. Hales, J., and M.G. Williamson. 2010. Implicit employment contract: the limits of management reputation for promoting firm productivity. Journal of Accounting Research (48): 147-176. Holmstrm, B. 1982. Moral hazard in teams. The Bell Journal of Economics (13): 324-340. Holmstrm, B., and P. Milgrom. 1991. Multi-task principal-agent analyses: Incentive contracts, asset ownership, and job design. Journal of Law, Economics, and Organizations (7, special issue): 24 52. Holmstrm, B. 1999. Managerial incentive problems: A dynamic perspective. Review of Economic Studies (66): 169 182. Indjejikian, R. 1999. Performance evaluation and compensation research: An agency perspective. Accounting Horizons (13): 147 157. Irlenbusch, B., and D. Sliwka. 2006. Career concerns in a simple experimental labor market. European Economic Review (50): 147 170. Koch A., A. Morgenstern, and P. Raab. 2006. An experimental test of career concerns. Working paper. University of London. Meyer M.A., and J. Vickers. 1997. Performance comparisons and dynamic incentives. The Journal of Political Economy (105): 547-581.

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Prendergast, C. 1999. The provision of incentives in firms. Journal of Economic Literature (37): 7 63. . 2002. Uncertainty and Incentives. Journal of Labor Economics (20): 115 138. Shields, M.D., and W.S. Waller. 1988. A behavioural study of accounting variables in performance-incentive contracts. Accounting, Organizations and Society (13): 581-594. Sillamaa, M.A. 1999. How work effort responds to wage taxation: A nonlinear versus a linear tax experiment. Journal of Economic Behavior and Organization (39): 219 233. Stevens, D. E. 2002. The effects of reputation and ethics on budgetary slack. Journal of Management Accounting Research (14): 153 171.

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TABLE 1 Agent s Mean Effort Allocated to Task B Relative to Total Effort (between brackets)

High Abilitya Career Concerns Fixed wage 0.26n=9 (45.44) 0.17 (48.44) 0.19 (51.67) 0.18 (52.11) 0.20 (49.40) Financial incentives 0.51 (35.63) 0.51 (40.63) 0.60 (44.38) 0.66 (46.88) 0.57 (41.88) No Career Concerns Fixed wage 0.42 (38.78) 0.35 (42.22) 0.45 (44.00) 0.38 (46.78) 0.40 (42.94) Incentives 0.54 (39.78) 0.62 (39.78) 0.72 (46.89) 0.92 (47.11) 0.70 (43.39)

Period 1 Period 2 Period 3 Period 4 All periods

Low Abilitya Career Concerns Fixed wage 0.58n=7 (34.14) 0.33 (39.71) 0.50 (43.14) 0.30 (45.86) 0.43 (40.71) Financial incentives 0.31 (35.40) 0.38 (39.50) 0.55 (41.60) 0.52 (43.40 0.44 (40.00) No Career Concerns Fixed wage 0.45 (40.00) 0.65 (36.67) 0.38 (45.00) 0.60 (46.33) 0.52 (42.00) Incentives 0.77 (37.33) 0.73 (41.89) 0.83 (44.33) 0.94 (43.56) 0.82 (41.78)

Period 1 Period 2 Period 3 Period 4 All periods

based on a median split of the measure of perceived own ability (mean=4.31, median=4. 50)

30

TABLE 2 Analysis of Effort Allocation Panel A: ANOVA on Effort Allocated to Task B in absence of Career Concerns Source of Variation Between-Subjects Dincentives Ability Dincentives Ability Error Within-Subjects Period Period Dincentives Period Ability Period Dincentives Ability Error SS 1.74 2.23 0.02 0.51 0.07 0.52 0.75 0.17 5.04 Df 1 6 1 30 3 3 18 3 72 MS 1.74 0.37 0.02 0.22 0.02 0.17 0.04 0.06 0.07 F 11.83 2.53 0.12 p-value p=0.002 p=0.049 p=0.729

0.34 2.48 0.59 0.80

p=0.793 p=0.09 p=0.892 p=0.497

Panel B: ANOVA on Effort Allocated to Task B in presence of Career Concerns Source of Variation SS Df MS F p-value Between-Subjects Dincentives 0.84 1 0.84 5.22 p=0.023 Ability 11.34 10 1.13 7.05 p=0.000 Dincentives Ability 2.43 1 2.43 15.11 p=0.000 Bonusprevious period 0.48 2 0.24 1.51 p=0.221 Error 32.33 201 0.16 Within-Subjects Period 0.41 3 0.14 2.31 p=0.075 Period Dincentives 0.46 3 0.15 2.62 p=0.050 Period Ability 2.86 30 0.10 1.62 p=0.021 Period Dincentives Ability 0.28 3 0.09 1.58 p=0.194 Period Bonusprevious period 0.51 6 0.08 1.43 p=0.200 Error 35.58 603 0.06 Dincentives is a dummy variable that equals one if the treatment is a financial incentive treatment and zero otherwise; Bonusprevious period is the labor market bonus paid to a participant based on performance in the previous period (equal to zero for the first period). There are four periods used for the analysis (five periods in total excluding the last period due to potential end-game effects). The dependent variable, effort allocated to Task B, is measured by the total number of correctly decoded numbers of Task B divided by the total number of correctly decoded numbers of both Task A and Task B.

31

TABLE 3 Repeated Measure Analysis of Effort Allocated to Task B (Periods1-4)

Independent variables Intercept Dincentives Dcareer concerns ABILITY Dincentives Dcareer concerns Dincentives ABILITY Dcareer concerns ABILITY Dincentives Dcareer concerns ABILITY
0 1 2 3 4 5 6 7

Estimate n = 67 0.48*** 0.28*** -0.16*** -0.19*** -0.04 0.12* 0.02 0.18**

The dependent variable is the mean effort allocated to the task measured with noise (Task B), with repeated measurement for periods 1-4. Effort allocated to Task B is measured by the total number of correctly decoded numbers of Task B divided by the total number of correctly decoded numbers of both Task A and Task B. The intercept reflects the treatment with fixed wages. Dincentives = a dummy variable that equals one if the treatment is a financial incentive treatment and zero otherwise. Dcareer concerns = a dummy variable that equals one if the treatment is a career concerns treatment and zero otherwise. ABILITY is the mean response on a 7-point Likert scale to two statements: I think I am pretty good at the experimental tasks and I am pretty skilled at the experimental task.with 1=absolutely disagree and 7=absolutely agree. ***, **, * is significant at the 1 percent, 5 percent, and 10 percent level, respectively (two-tailed).

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TABLE 4 Ordered-Probit Regression of Wage Offers FIRSTOFFER of principals to agents

Independent variables Intercept rA rB DFW

0

Predicted sign

All Periods n = 136 -2.67*** (-4.42)

Period 1 n = 34 -1.02 (-0.93) 0.03** (2.48) -0.01 (-0.55) 0.08 (0.02)

Period 2 n = 34 -1.90* (-1.68) 0.02 (1.34) 0.02** (2.07) 0.42* (1.91)

Period 3 n = 34 -4.53*** (-3.33) 0.07*** (3.55) 0.04*** (2.94) 0.17 (0.40)

Period 4 n = 34 -7.88*** (-3.70) 0.09*** (3.78) 0.07*** (3.43) 0.17 (0.37)

+ +

0.04*** (5.15) 0.02*** (3.56) 0.24 (1.19)

The t-statistics are in parentheses. FIRSTOFFER is the initial additional wage offered to an agent by the other principal after each period. rA = the performance measure for Task A (precise measure). rB = the performance measure for Task B (noisy measure). DFW = a dummy variable that equals one if the treatment is a fixed wage treatment and zero otherwise. The dependent variable is the initial FIRSTOFFER. The intercept reflects the treatment financial incentives. ***, **, * is significant at the 1%, 5%, and 10% level, respectively (two-tailed).

33

TABLE 5 Ordered-Probit Regression of Wage Changes WAGECHANGES for agents

Independent variables Intercept rA rB DFW

0

Predicted sign

All Periods n = 136 -1.42** (-2.44)

Period 1 n = 34 0.05 (0.05) 0.03** (2.29) 0.00 (0.30) -1.27*** (-2.68)

Period 2 n = 34 -0.40 (-0.37) 0.01 (0.99) 0.01 (1.02) 0.26 (0.65)

Period 3 n = 34 -3.58** (-2.54) 0.07*** (3.43) 0.03*** (2.52) -0.36 (-0.86)

Period 4 n = 34 -9.20*** (-3.65) 0.10*** (3.65) 0.10*** (3.72) 0.06 (0.11)

+ +

0.03*** (4.38) 0.02*** (2.99) -0.29 (-1.41)

The t-statistics are in parentheses. WAGECHANGES, is the actual change in extra wages paid by the principals. rA = the performance measure for Task A (precise measure). rB = the performance measure for Task B (noisy measure). DFW = a dummy variable that equals one if the treatment is a fixed wage treatment and zero otherwise. The dependent variable is the initial WAGECHANGES. The intercept reflects the treatment financial incentives. ***, **, * is significant at the 1%, 5%, and 10% level, respectively (two-tailed).

34

FIGURE 1 The experimental procedure

1--------2--------3--------4-------5-------6-------7

Period t

Period t+1

1. 2. 3. 4. 5. 6. 7.

Agents work on experimental task Two performance signals are communicated to the labor market (principals) Principals make first offers to those agents that are assigned to them in the current period Principals receive information on the first offers and make counter offers to those agents that are not assigned to them in the current period The highest offer is communicated to the agent. In case of equal offers, the offer of the principal of the current period is communicated. Principals receive information which agent will be working for them in the next period as a result of the wage offers The next period begins. Agents start to work on the experimental task again (1).

35

Figure 2: Effort allocated to Task B Panel A: Absence of Career Concerns

0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 fixed wage incentives low ability high ability

Panel B: Presence of Career Concerns

0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 fixed wage incentives low ability high ability

36