Bonus versus Penalty: Does Contract Frame Affect Employee Effort?

Abstract

We conducted an experiment in which participants acted as employees under either a bonus contract or an economically equivalent penalty contract. We measured participants’ contract preference, their degree of expected disappointment about having to pay the penalty or not receiving the bonus, their perceived fairness of their contract, and their effort level. Consistent with Luft (1994), we find that employees generally preferred the bonus contract to the penalty contract. We extend Luftŕss work by demonstrating that loss aversion caused employees to expend more effort under the penalty contract than under the economically equivalent bonus contract. That is, employees were more averse to having to pay the penalty than they were to not receiving the bonus, and consequently they chose a higher level of effort under the penalty contract to avoid paying the penalty. However, we also find evidence of reciprocity in that employees who considered their contract to be fairer chose a higher level of effort. Because our participants generally considered the bonus contract fairer than the penalty contract, reciprocity predicts higher effort under the bonus contract, a result opposite to our finding. Our overall result that employee effort was greater under the penalty contract is explained by the fact that, while higher perceived fairness did increase effort, this effect was dominated by the more powerful opposing effect of loss aversion. We discuss the implications of these results for explaining why in practice most actual contracts are bonus contracts rather than penalty contracts.

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