It is sometimes suggested that compensation varies across individuals much more dramatically than would be expected by looking at variations in their marginal products. This paper argues that a compensation scheme based on an individual's relative position within the firm rather than his absolute level of output will, under certain circumstances, be the preferred and natural outcome of a competitive economy. Differences in the level of output between individuals may be quite small, yet optimal "prizes" are selected in a way that induces workers to allocate their effort and investment activities efficiently.

It is sometimes suggested that compensation varies across individuals much more dramatically than would be expected by looking at variations in their marginal products. This paper argues that a compensation scheme based on an individual's relative position within the firm rather than his absolute level of output will, under certain circumstances, be the preferred and natural outcome of a competitive economy. Differences in the level of output between individuals may be quite small, yet optimal "prizes" are selected in a way that induces workers to allocate their effort and investment activities efficiently.

Much of the theory in personnel economics relates to effects of monetary incentives on output, but the theory was untested because appropriate data were unavailable. A new data set for the Safelite Glass Corporation tests the predictions that average productivity will rise, the firm will attract a more able workforce, and variance in output across individuals at the firm will rise when it shifts to piece rates. In Safelite, productivity effects amount to a 44-percent increase in output per worker. This firm apparently had selected a suboptimal compensation system, as profits also increased with the change.

and the Hoover Institution Partnerships and profit sharing are often claimed to motivate workers by giving them a share of the pie. But in organizations of any significant size, the free-rider effects would seem to choke off any motivational forces. This analysis explores how peer pressure operates and how factors such as profit sharing, shame, guilt, norms, mutual monitoring, and empathy interact to create incentives in the firm. The argument that Japanese firms enjoy team spirit because compensation is linked to overall profitability is analyzed. An explanation for the prevalence of partnerships among individuals in similar occupations is provided. Many firms that use profit-sharing plans claim that such plans have beneficial incentive effects. Partnerships, which share profits, not necessarily equally among partners, are thought by their owners to have some incentive features that are lacking in an employer/employee relationship. Indeed, the idea has even made its way down Madison Avenue into television advertising. Witness, for example, the recent ads for Avis Corporation that boast that the employees are owners and therefore will work harder to serve the customer. But the idea that joint ownership can do much for incentives when the number of workers is large seems wrong on the face of it. After all, each worker We thank Eugene Fama, Peter Mueser, Kevin J. Murphy, and Sherwin Rosen for helpful comments. Financial support was provided by the National Science Foundation.