Differentiation and Performance: An Empirical Investigation on the Incentive Effects of Bonus Plans

It is often claimed that supervisors do not differentiate enough between high and low performing employees when evaluating performance. The purpose of this paper is to study the incentive effects of this behavior empirically. We first show in a simple model that the perceived degree of past differentiation affects future incentives. We then study the impact of differentiation empirically with a large panel data set spanning many firms in one industry. On average, stronger differentiation has a substantial positive effect on performance. This effect is larger on higher hierarchical levels. But differentiation may become harmful at the lowest levels.