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Why Do Firms Use Non-Linear Incentive Schemes? Experimental Evidence On Sorting And Overconfidence

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Executive Summary

Non-linear incentive schemes are commonly used to determine employee pay, despite their distortionary impact. The author investigates possible reasons for their widespread use by examining the relationship between convex pay schemes and overconfidence. In a laboratory experiment, subjects chose between a piece rate and a convex pay scheme. They find that overconfident subjects are more likely than others to choose the convex scheme, even when it leads to lower pay. Overconfident subjects also persist in making the mistake despite clear feedback. These results suggest non-linear pay schemes may help companies select and retain overconfident workers, and may reduce the wage bill.

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