pay plan options

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Let us discuss each plan one by one:

Merit-based pay:

Heneman (1992) defines merit awards as incentive pay that is based upon past performance and is designed to motivate future performance. Where individual employees are responsible for complete tasks with measurable effects on the total output of the firm, the links between rewards for past performance and future effort are strengthened; conversely, where teamwork is an important component of the production process, it is not only more difficult to evaluate individual performance, but financial rewards may not elicit the appropriate cooperative behaviour among employees. Moreover, financial rewards may diminish the intrinsic value individuals place upon their work; they may decrease the employees' self-esteem if they deem merit awards to be too infrequent or if they hold an inflated self-evaluation of their performance; or may generate the "Matthew effect" where the motivation of underperformers declines and overperformers experience a sense of guilt (Heneman 1992: 49-56).

Economists applying agency theory reach much the same conclusion. Lazear and Rosen (1981) characterize merit pay as a "rank-order tournament," where individuals compete for salary "prizes" on the basis of relative, rather than absolute, performance. Where it is difficult for firms to obtain an absolute measure of worker productivity, or where it is cheaper to obtain an relative measure, firms establish a competitive game among employees and reward the winners with a prize. They offer the example of a handful of junior executives vying for a senior executive position within a firm. Differences in performance may be marginal and the best that can be achieved is a ranking of individuals. By offering promotion and a raise to the most productive, an incentive is created for all competitors to increase their output. Although the winner's new salary may exceed his/her value to the firm, it is an efficient arrangement if the total increase in productivity of all contestants is sufficiently large to justify the winner's higher salary (Lazear and Rosen 1981). Similarly, merit pay schemes involve a zero-sum game relying upon a relative measure of output among contestants vying for a salary prize. A fixed pool of funds is distributed among employees exhibiting the greatest production over an interval of time with the "more exceptional" rewarded by transferring funds away from "less exceptional" performers.

If the salary prize induces enough greater effort, the value of the resulting increase in productivity exceeds the higher salary costs. Alternatively, if production relies upon a high degree of cooperation among employees - in the form of common tasks, or the transfer of knowledge through on-the-job training - merit pay may be inefficient. Rank-order tournaments based upon relative performance create an incentive to withhold cooperative effort. According to Lazear (1989: 578-9): ...