An Experimental Investigation of the Effects of Contract Frame and Discretion in Performance Evaluation on Effort

The design of incentive compensation plans is critical to a company’s success. This study develops and validates a theoretical model to examine how incentive contract framing affects effort. This study uses an experiment to observe the effect of the manipulation of incentive contract frame and the presence or absence of principal discretion in performance evaluation on effort. The results of the experiment show that when principal discretion in performance evaluation is absent, penalty contracts induce greater effort than bonus contracts. The results of the experiment also demonstrate that the interaction of principal discretion in performance evaluation and contract frame influences how agents view the perceived fairness of their incentive contract. Specifically, principal discretion in performance evaluation increases perceived fairness under a penalty contract but not under a bonus contract. This study also extends prior research by documenting that perceived fairness explains how incentive contract frame affects trust and effort