Companies want workers to put in more effort, and workers want to be rewarded more. Two types of incentive contracts are used to address this: explicit and implicit contracts. Explicit contracts reward based on performance, while implicit contracts reward based on subjective evaluations. Both have their own advantages and disadvantages and should be used in combination to best fit the situation.
Companies want workers to work harder than they are rewarded, while workers want to get more from the company for their efforts. To mitigate this conflict of interest, an incentive contract is a promise to ensure that the compensation a worker receives reflects the worker’s effort. There are two ways to use incentive contracts: explicit and implicit.
Explicit incentive agreements
An explicit contract is a promise that is enforced by a third party, such as a court, so it must be based on objectively verifiable terms. Because a worker’s effort cannot be objectively verified, an explicit incentive contract is a promise to compensate the worker based on the outcome of the effort instead of the effort. This creates a very strong incentive for workers to increase their effort.
For example, if the compensation scheme for a worker is “fixed pay + 𝜶 × performance” (0≤ 𝜶 ≤1), then as 𝜶, the strength of the incentive, increases, the worker will put in additional effort based on the performance pay in addition to the base effort based on the fixed pay. Increasing 𝜶 will result in more extra effort as the worker’s effort level increases, so the firm’s profits will increase even if the worker receives a larger share of the extra effort, because unlike the base effort, the worker will keep a larger share of the extra effort.
However, there are two problems with explicit incentive contracts that cause the firm’s profit to decrease as 𝜶 increases. First, explicit incentive contracts make the worker’s income uncertain, because the worker’s performance is affected not only by the worker’s effort but also by chance factors such as the work situation, conditions, and luck. However, in order to make the worker accept the uncertainty of income, the firm must pay the worker additional compensation in the form of a risk premium. Therefore, as 𝜶 increases, the compensation that the firm must pay the worker increases, which reduces the firm’s profit.
Second, explicit incentive contracts introduce an incentive distortion problem that causes workers to focus their efforts on being well compensated. This is because some performance is easy to measure and some is not. If workers neglect important but difficult-to-measure tasks that are not sufficiently rewarded, it will be detrimental to the performance of the firm as a whole. Therefore, as 𝜶 increases, the problem of perverse incentives is exacerbated, and the firm’s profits may decrease.
Implicit incentive contracts
Implicit incentive contracts may be more effective when it is difficult to find a reasonable performance metric and the problem of incentive distortion is important. Implicit incentive contracts reward workers in the form of bonuses, benefits, promotions, etc. based on a subjective assessment of their efforts, regardless of performance. Implicit agreements are not actually contracts that can be protected by law. According to this theory, a contract is fulfilled when a party voluntarily acts to meet the other party’s expectations when it is in their long-term interest to continue working with the other party.
With an implied contract, there is no way to legally force a party to stop working together if they believe there is a short-term benefit to be gained by violating the other party’s expectations. However, once a party loses the trust of the other party, it cannot expect voluntary cooperation from that party. Therefore, when relying on implicit incentive agreements, it is important to ensure that workers trust that the organization’s evaluation and compensation are fair.
Conclusion and further considerations
When choosing the type of incentive agreement, organizations should consider a variety of factors. For example, you should evaluate whether you can objectively measure worker performance, how tolerant workers are of uncertainty, and how important it is to maintain a working relationship over the long term. You also need to design an incentive structure that fits your company culture and organizational characteristics. When incentive contracts are well designed and operated, they can lead to beneficial outcomes for both companies and workers.
Therefore, it is important to understand the advantages and disadvantages of both explicit and implicit contracts, and to apply the right mix of both in the right context. Companies should continuously monitor and feedback to improve their incentive systems to maximize both worker motivation and company performance.
