Annullable bonuses and penalties

An annullable penalty is a sanction that is applied unless monitoring takes place and the agent is found non-shirking. An annullable bonus is a bonus that the agent receives unless he has been monitored and found shirking. Annullable penalties and bonuses stand in contrast with normal penalties and bonuses, which are only applied if monitoring has taken place. While real-life examples of annullable penalties are rare (an example is a sanction for which the burden of proof is reversed), there is a clear and oft-discussed example of annullable bonuses: efficiency wages. Under efficiency wages all employees receive a bonus (an overpayment), except for those who have been monitored and found shirking.

This paper analyzes under what conditions annullable bonuses or penalties make economic sense. On the one hand, annullable bonuses and penalties have a degree of ineffectiveness that is absent in their normal counterparts: the penalty paid by or the bonus paid to non-monitored agents does not improve their incentives. Not only does this ineffective part make the expected sanction or bonus higher than necessary but it also creates an implicit tax on low monitoring levels and hence distorts monitoring choices. On the other hand, the annullable variants may change the ex post incentives of the agents (to come up with evidence) and the principal (to monitor as promised). As a result, annullable bonuses (such as efficiency wages) can be rational choices when the principal cannot credibly commit to paying bonuses with a certain probability, and annullable penalties can make sense when the agent needs an incentive to reveal information.

Keywords: Effectiveness of sanctions; Contract remedies; Carrots and sticks; Efficiency wages; Burden of proof