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Reducing Errors

The effect of framing on quality and effort

Tessa Dik

10423885

Managerial Economics and Strategy

University of Amsterdam

Supervisor:

Dr. S. Onderstal

University of Amsterdam

Abstract

In this experiment, I ran a real effort experiment at the University of Amsterdam consisting of 182 first-year Economic and Business BSc. students to research the following question: “Could the quality of relatively easy tasks be increased using framing of piece-rate incentives without a reduction in effort?” I find no statistically significant differences in quality or effort resulting from framing of piece-rate incentives. There are also no differences found in quality when changing from a fixed fee contract to a framed piece-rate incentive contract. However, effort increases significantly in all framed piece rate contracts compared to a fixed

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“Strive for continuous improvements, instead of perfection”

-Kim Collins-

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Index

Page

1. Introduction ………. 4

2. Literature review ………. 6

2.1 Principal-Agent theory……….. 6

2.2 Design of payment schemes ………. 6

2.3 Payment schemes……… 7 2.3.1 Fixed Wage………... 7 2.3.2 Piece-rate………... 8 2.4 Behavioural theory……… 8 2.5 Empirical Findings……… 9 2.5.1 Motivation……….. 10 2.5.2 Fixed wage……… 10 2.5.3 Framing……….. 10 2.5.3.1 Reward incentives ………... 11 2.5.3.2 Punishment incentives………. 11

2.5.3.3 Combination of Reward & Punishment incentives………….. 11

2.5.4 Limitations existing literature……….. 12

2.6 Summary ………... 12

3. Experimental design & procedures………... 14

3.1 Design………... 14

3.1.1 Risk aversion & Loss Aversion………... 16

3.2 Definitions……….. 16

3.3 Design of payment scheme………... 16

3.4 Procedures………... 18 3.5 Summary……… 19 4. Hypotheses………... 20 5. Experimental Results……….. 22 5.1 Data………... 22 5.2 Control round ……… 23 5.3 Treatment Results……… 24 5.4 Fixed to Framing………... 26 5.5 Summary ……….……….. 28

6. Indications of selection effects………... 29

6.1 Selection effects resulting from framing……… 29

6.1.1 Contract choice………. 29

6.1.2 Contract preferences……… 30

6.1.3 Contract Perception………. 30

6.2 selection effects of contract composition ………. 31

6.2.1 Heterogeneity……… 31

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1. Introduction

In order to perform well and to reach the goals of organisations, agents are motivated by the organisation in different ways. Given the motivational incentives from the organisation, agents choose their effort levels and perform the tasks they face. As an agent, it is inevitable to make errors during these tasks, and not all errors can be prevented. However, errors could become expensive for an organisation to correct, with respect to time and costs. Avoidable errors can occur because of a lack of effort, motivation or concentration in easy tasks. Errors following from a lack of skill are harder to avoid (Bonner, Hastie, Sprinkle & Young, 2000). Every organisation benefits from a decrease in errors, which would mean an increase in quality, in particular, if this is reached without a decrease in the chosen effort levels and therefore without a decrease in the productivity of the agents.

A way to motivate agents is through monetary incentives. Monetary incentives could be framed as a reward or a punishment. Standard agency theory predicts the same quality and effort level for economically equivalent contracts (Eisenhardt, 1989). So framing of a contract should have no effect on individual behaviour. Behavioural theory argues that framing alters our understanding of the setting (Ariely, 2008). It sets reference points which are either a gain or a loss. When risk attitudes differ, depending on gains or losses, the framing of a problem may influence individual behaviour, even if the economic value of the contract is exactly the same. This theory is contrary to standard agency theory.

There are (experimental) studies in the existing literature about the framing effects of rewards or punishment separately on quality and effort. Some indicate that rewards increase effort and decrease quality (Paarsch & Shearer, 2000; Lazear, 1996). Other argue that this effect is reversed for punishment incentives (Luft, 1994; Hossain & List, 2012). There are also a few studies about the combination of reward and punishment incentives. Combining reward & punishment incentives could lead to a trade-off of advantages and disadvantages of both incentive framings. They could, therefore, act as complements in encouraging desired behaviour (Andreoni, Harbaugh & Vesterlund, 2003). The studies about reward & punishment incentives indicate that effort and quality both increase compared to pure rewards or pure punishment incentives (Armantier & Boly, 2015). Therefore, the existing studies on framing indicate that framing has a significant effect on the behaviour of agents concerning quality and effort decisions.

The existing literature consists of studies about framed incentives, with the use of target levels. Target levels could give extra and other incentives besides the desired incentives on quality and effort (Merchant & Manzoni, 1989). A framed piece-rate payment scheme without target levels leads not to such extra incentives. The effects of the combination of reward & punishment incentives on quality and effort in a piece-rate setting without target levels, is to the best of my knowledge, not investigated yet. Therefore, the aim of this experimental study is to identify the effects of framing and especially of combining reward & punishment incentives on quality of the tasks that agents face and the effort levels chosen in a piece-rate incentive scheme without target levels. Hence, a piece-rate combination contract of reward & punishment incentives will be included, together with pure reward and pure punishment piece-rate incentives. This improves the robustness of this research and allows for the exploration of differences across framing settings.

This research has practical relevance to managers, since it helps them to obtain a better understanding of the effects for the organisation resulting from framing of payment schemes. Those effects could be reached with almost no extra financial costs because only the wording of the contracts has to be changed.

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The aim of this study is not to state that piece-rates are good, but that the composition and framing choice of payment schemes have important implications for quality and effort levels in organisations. It seems plausible that the effects will be larger if the monetary incentives become larger and if control measurements of the task become more precise.

Based on the above, the research question is formulated as follows:

“Could the quality of relatively easy tasks be increased using framing of Piece-Rate incentives without a reduction in effort?”

I ran a real effort experiment at the University of Amsterdam consisting of 182 first-year Economic and Business BSc. students. The results of this research extend the existing literature with the framing effects of reward & punishment incentives on quality and effort without the use of target levels. I find no statistically significant differences in quality or effort resulting from framing of piece-rate incentives. There are also no differences found in quality when changing from a fixed fee contract to a framed piece-rate incentive contract. However, effort increases significantly in all framing settings compared to a fixed fee contract. A questionnaire indicates possible selection effects. This study concludes that the number of errors cannot be reduced, which indicates an increase in quality, using framing of piece-rate incentives. Further research is needed to overcome some limitations of this experiment and to explore selection effects resulting from framing.

This study is structured as follows. Section 2 is an overview of the existing literature concerning Principal-Agent theory, behavioural theory and empirical findings with respect to motivation, contracts, incentives and framing. Section 3 describes the experimental design and methodology of this experiment. The corresponding hypotheses are presented in section 4. The results are presented in section 5. Section 6 discusses indications of selection effects. Limitations of this study are discussed in section 7. This study closes off with a conclusion which gives an answer to the research question.

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2. Literature review

This section reviews the existing literature to provide a complete overview of the research problem. It outlines the research that has been done on the topic of framing monetary incentives and the effects on quality and effort. In the first section, principal agency theory will be discussed. Section 2 and 3 will explain contract designs and payment scheme models. Section 4 discusses behavioural theories. Section 5 discusses the (experimental) results of existing literature on framing settings: rewards, punishments and a combination. This section concludes with a short summary of the discussed literature.

2.1 Principal-Agent Theory

All the work in an organisation is done by agents that are instructed by an organisation. It is important to understand agents‘ motivations in order to be able to influence them in a favourable way for an organisation with the use of incentive contracts. First, motivation will be discussed, followed by principal-agent theory.

There are two forms of motivations following from self-determination theory (Deci & Ryan, 1985); Intrinsic (autonomy) motivation and extrinsic (controlled) motivation. Intrinsic motivation refers to doing something because it is interesting or enjoyable for the individual himself. Extrinsic motivation refers to doing something because it is expected, asked or required and leads to a desirable outcome (Ryan & Deci, 2000).

One of the extrinsic methods to motivate people is a monetary incentive. There are different kinds of monetary incentives, either positive incentives (reward) when the incentivised action is desirable, or negative incentives (punishment) if the incentivised action is not desirable.

Organisations that incentivise agents with monetary incentives use contracts to agree to conditions. A contract theory about motivating workers in an organisation is the principal agent theory. Standard principal agency theory is about an optimal contract that delegates work to an agent and aims to incentivise agents to make optimal decisions (Hölmstrom, 1979). This theory assumes that the principal will be in a setting with incomplete information (Jensen & Meckling, 1976). Incomplete information follows from adverse selection or moral hazard. In both situations, the agent has an information advantage because the principal cannot assess the agent‘s behaviour perfectly (Holmstrom & Milgrom, 1991). The agent takes actions on behalf of the principal that will impact both of their payoffs. Therefore, the agent could behave opportunistically by decreasing his effort, because exerting effort is costly and decreases utility (Eisenhardt, 1989). Because of this, misalignment between interests exists. Principal-agent theory is about aligning the principal‘s and agent‘s interests with the use of monetary incentives in contracts (Fong & Tosi, 2007). Sprinkle (2003) argues that monetary incentives have a decision influencing role and are therefore considered to solve control and delegation issues within an organisation.

In the standard (simple) model of agency theory, introducing extrinsic incentives cannot lower effort levels chosen by the agent. Without extrinsic incentives, effort is necessarily at the lowest possible level (Kreps, 1997).

2.2 Design of payment schemes

With an information asymmetry, the principal has two contracting options. The principal can offer an outcome-based contract based on performance outcomes. Or the principal could offer a behaviour-based contract that assesses information on agent‘s behaviour (Fong & Tosi, 2007). With an output-based contract, also called incentive contract, the output serves

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as an indicator for effort behaviour of the agent (Eisenhardt, 1989). Incentive contracts motivate agents to maximise their compensation, thereby simultaneously maximise principal‘s payoffs and overcome misalignments of interests (Cadsby, Song,& Tapon, 2007).

There are different payment schemes possible in contracts. The two main forms are fixed payments and variable payments. Following Lazear (1998), a payment scheme could be constructed as the following linear function:

Agent‘s payoff function:

The parameters and are compensation parameters set by the firm and represents output. Coefficient represents the level of a base salary and represents the variable part of payment. The firm sets the compensation parameters, and will edit those in their firm specific payment schemes accordingly.

The output of an agent depends on his invested effort level and on exogenous stochastic shocks. Therefore the output function is as follows:

Output function:

Here, parameter represents effort and parameter represents a shock. Effort ( ) is positively related to output. The shock ( ) can either affect output positively or negatively.

2.3 Payment schemes

Two different payment schemes that could be distinguished with the use of a linear contract design are fixed wage payment schemes and variable payment schemes. From the different variable payment schemes, a piece-rate payment scheme will be discussed in this study. 2.3.1 Fixed Wage

A fixed wage contract is the most often used contract and is a compensation form which is independent of any outcome. It depends on a behavioural measurement (Lazear, 1986).The wage is rewarded for a workers‘ input. Often time is used as a proxy for effort, because it is easy to measure (Lazear, 1995). Fixed wages are often used when output is difficult to measure because of complexity, diversity or creativity, or if exogenous stochastic shocks occur which affect the output of workers (Lazear, 1995). A fixed wage will, in this case, prevent agents and principals from undesirable risk and costs.

Recall Lazear (1998) function and as described in section 2.2. Agent‘s payoff function: . In a fixed wage payment scheme, there is no variable part depending on a measure of output. Therefore the compensation parameter β will be 0. Hence, the only parameter of interest is the compensation parameter . Parameter is assumed to be a positive parameter ( ) that represents the base salary. A firm could choose parameter in a way that fits the organisation best.

According to agency theory, only the performance-dependent part of the compensation has an incentive effect and drives the agent‘s decisions (Lazear, 1995). The

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2.3.2 Piece-rate

Another contract form is a variable compensation scheme. It is dependent on some measurement for outcome or behaviour (Lazear, 1998). A commonly used variable payment scheme is a piece-rate payment scheme.

A piece-rate compensation scheme is an outcome-based contract. Piece-rate payment schemes are often used when output is relatively easy to measure. Examples of industries where piece-rate pay contracts are common are agricultural industry, call centres, writing, logistics, administration, cleaning, and manufacturing (Seiler, 1982). It is often a linear function of output like described before. In a piece-rate contract design, a worker is free to choose its own invested time and effort level for the tasks. Piece-rates are also used when there are almost no exogenous stochastic shocks which affect the output of workers (Lazear, 1995). If there are shocks, the worker bears the financial risk of it. At the same moment, a firm loses an accurate measurement for effort, because the shock affects output and output is the measure of effort.

Recall the payment scheme functions of Lazear (1998) function and as described in section 2.2. Agent‘s payoff function: . In a full incentive-based payment scheme, there is no base salary and therefore compensation parameter . The only parameter of interest is the variable compensation parameter . Parameter is assumed to be a positive parameter.

An incentive-based payment scheme could also have a base salary. In that case, it is not a full incentive-based payment scheme anymore. Then, both compensation parameters and could be chosen by the firm to incentivise the agent.

When constructing a piece-rate payment scheme, the equal compensation principle should be carefully examined. If in a multitasking setting not all activities are incentivised in line with the interests of the organisation, workers will misallocate their effort to get the highest compensation (Holstrom and Milgrom, 1991).

Standard principal-agent theory predicts an equivalent effort level for each agent when they face the identical monetary incentive levels. So framing should not influence individual behaviour of agents.

It is often easier to obtain an approximation of input for an input based contract than to obtain a fair approximation of an output measure (Baland & Platteau, 1999). Measures require monitoring, which can become very costly. If measurement costs become higher, a fixed wage is more attractive for the organisation (Lazear, 1989). The optimal contract depends on the benefits of incentivised workers and the monitoring cost of the different contract forms.

2.4 Behavioural theory

There are other theories which predict agents‘ behaviour, besides standard economic principal-agent theory. Psychology and economics are combined in behavioural theories. This section outlines the predictions of behavioural theory on motivation, incentives, and framing.

A general expectation in the standard principal-agent theory is that extrinsic motivation has a positive impact on motivation, because extrinsic motivation is added on top of intrinsic motivation (Bonner & Sprinkle, 2002). However, motivation crowding theory (Frey & Jegen, 2001) argues that monetary incentives are not an effective motivator because intrinsic motivation for a task will be affected negatively by giving extrinsic monetary incentives. This is called the ―motivation crowding effect‖ (Deci, 1972; Lazear, 1991; Prendergast, 1999).

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Concerning variable contracts, Piece-rate contracts can have economically equivalent framing settings. Framing presents equivalent choices using different wordings (Ariely, 2008). A problem can be formulated in different ways, a gain frame (rewards) and a loss frame (punishment) (Kahneman, Tversky, 1979).

Behavioural economists like Ariely (2008) challenge the common assumption that economic agents know their preferences. Rational choice theory and preference logic assume that preferences are complete and transitive. Ariely (2008) suggests that framing alters our understanding of the setting. From psychology‘s prospect theory follows that people evaluate outcomes in relative terms, not in absolute terms (Nosenzo, 2016). Context is important because context provides anchors that enable people to make relative judgments. People are good in relative judgments and choices but absolute judgments are hard according to Zimmerman (2009). For relative judgments, a reference point is needed, which is either a gain or a loss. Most people are loss averse. This means that they are more sensitive to losing things they have, than to the satisfaction of gaining new things (Kahneman, Tversky, 1979). When risk attitudes differ, depending on wins or losses, the framing of a problem may influence individual behaviour. This is contrary to standard agency theory which predicts the same effort level for economically equivalent contracts.

If agents are loss averse, it may be effective to use the framing in the wordings used in contracts, to describe incentives to agents (Kahneman, Tversky, 1979). Presenting rewards as an extra incentive that can be gained by reaching a performance, or as an entitlement that could be lost if the agent fails to reach that performance. The endowment effect also uses this principle, which states that people ascribe more value to the things they own, than they are willing to pay to acquire the same object (Kahneman, Knetsch & Thaler, 1991). In the case of monetary incentives or contracts, the object to gain or lose is money. Under loss aversion, the fear of losing a reward acts as a greater motivator than the attraction of gaining it, even if the economic value of the reward is exactly the same. Framing can have an effect on the behaviour of agents without extra financial costs for the firm by only changing the wordings of contracts.

Therefore, the effects of rewards and punishments could be different. Theories argue that a punishment framing may be perceived as unfair and controlling and therefore triggers a decrease in effort, which is argued by Kohn (1993), Luft (1994) and Hannan, Hoffman & Moser (2005). If people feel they are mistreated, it might change their behaviour in a counterproductive way that damages the organizations, by reducing effort or quality or for example committing theft, sabotage or by excessive use of materials (Hannan, Hoffman & Moser, 2005). The psychologist Baumeister (1984) shows and describes the phenomenon ―choking under pressure‖ which entails a negative relationship between monetary incentives and quality, when effort increases. The focus of attention on monetary incentives can distract and cause loss of concentration and a shift from automatic behaviour to controlled, more conscious behaviour. This leads to lower quality levels (Baumeister, 1984).

Overall, standard agency theory which predicts the same effort level for economically equivalent contracts, behavioural theory predicts that individual behaviour is influenced by framing.

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2.5.1 Motivation

In the standard (simple) model of agency theory, introducing extrinsic incentives cannot lower effort levels chosen by the agent. Without extrinsic incentives, effort is necessarily at the lowest possible level. Extrinsic motivation is added on top of intrinsic motivation (Bonner & Sprinkle, 2002).

However, psychologists Deci and Ryan (1985) found evidence for intrinsic motivation in their experiment. In their experiment, participants made efforts even without facing monetary incentives.

A meta-analysis of 128 experimental psychology studies of Deci, Koestnerand Ryan (1999) examined the effects of extrinsic monetary incentives on intrinsic motivation. They conclude that monetary incentives significantly undermine free choice intrinsic motivation and self-reported interest and support therefor the motivation crowding theory. The comments made by Eisenberger, Pierce, and Cameron (1999) on the meta-analysis of Deci et al. (1999) argue some non-monotonic effects of monetary incentives on intrinsic motivation, depending on the performance requirement. Poorly defined requirements decrease intrinsic motivation and well-defined requirements do not.

2.5.2 Fixed wage

Only the performance dependent part of the compensation drives the agents‘ decisions according to agency theory. So a fixed wage should not influence the effort decision of a person. If only a fixed wage is offered, according to standard theory, an agent should exert the lowest effort possible because effort is costly and a principal should offer the lowest wage possible (Fehr, Kirchsteiger, & Riedl, 1993)

Fehr, Götte, and Lienhard (2008) show in a field experiment, a more realistic environment, that higher wages are paid than predicted by standard theory. Chen and Edin (2002) explain this with market forces. They state that a way to motivate people with a fixed wage contract is to pay agents above-market wages. If the agents decrease their effort and get caught, the agent is fired and the possible outside options will be less attractive compared to the organisation with the above-market wages (Chen & Edin, 2002).

Concerning effort levels, Fehr, Götte and Lienhard (2008) also found higher effort levels with a fixed wage contract than predicted by standard agency theory. Manthei and Mohnen (2013) argue that this result is not necessarily the case for all agents; it is especially the case for reference dependent and loss-averse agents. Chen and Edin (2002) explain this with reciprocal behaviour. Agents who have a job want to keep the job and therefore exert effort in return for the principal.

2.5.3 Framing

Standard theory predicts that economically equivalent framing settings have no effect on agents‘ decisions. Behavioural theory argues that framing alters the understanding of agents and therefore influences behaviour. The concept of framing is studied in practice. The literature consists of comparisons between a fixed wage and a framed piece-rate contract, and between framing settings. The different framing settings are rewards, punishments, and a combination of reward & punishment incentives. This section starts discussing some results studies on the different framing settings, respectively, in more detail. Each framing setting section will start with the literature on effort followed by literature on quality.

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2.5.3.1 Reward incentives

The most often used piece-rate framing is a reward framing. The effects of switching from a fixed wage to payment scheme with rewards are most often studied. A reward payment scheme often uses target levels.

The effect of a reward setting on effort is studied by Paarsch and Shearer (2000). They estimated an increase in productivity, because of rewards, between 8.8% and 60.4%. Lazear (1996) conducted a field experiment and found that a switch from fixed wage to a reward piece-rate was associated with an increase of 44% in productivity. They both conclude that a reward framing increases effort levels and therefore productivity. Contrary is the result of Bonner et al. (2000). They reviewed 131 experiments and found that monetary reward incentives only in half of the experiments had a positive effect on performance. The negative effects followed mostly from lack of ability for the tasks, unclearly defined targets, and complex tasks.

Not much research is done on the effect of piece-rate payment in combination with reward incentives on quality. Most studies focus on effort and are controlling for quality levels. This is remarkable, because poor quality of work is one of the main concerns of the agricultural industry using piece-rate payment in the research of Billikopf (1996). Freeman and Kleiner (2005) argue that a reward piece-rate payment scheme gives workers an incentive to decrease quality or to use excessive amounts of materials. Lazear (1986) also argues that piece-rate stimulates workers to produce too many units of output of low quality. 2.5.3.2 Punishment incentives

Another framing that is used, is a punishment framing. Rewards and Punishments are very closely related because a punishment is, in essence, a negative reward (Kohn, 1993).

There are different studies on the effect of punishment incentives on effort. Nonsenso (2016), Van de Weghe and Bruggeman (2004) and Hossain and List (2012) showed (experimentally) that punishment incentives within a framing setting improve effort compared to a fixed wage contract. The use of punishment framing can also cause significant negative behaviour compared to reward framing, due to fairness concerns (Hannan, Hoffman & Moser, 2005). In a study with a punishment and a reward framing, Luft (1994) asked the participants to rate the fairness of the incentives they faced in the experiment. The reward incentives are rated as being fairer than the punishment incentives.

Similar to studies about reward incentives, there is not much research about quality effects of punishment incentives. One of the studies that focus on quality is a study of Armantier and Boly (2015). They showed that a punishment framing of incentives outperformed a reward framing of incentives on quality. Lazear (2000) also concluded that quality increased with the use of a punishment payment scheme compared to a reward payment scheme and a fixed wage.

2.5.3.3 Combination of Reward & Punishment incentives

The effects of a combination of reward & punishment incentives on quality and effort are not often studied in the existing literature. But it could be useful to study according to Andreoni,

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Brink (2008) did two experiments with different economical equivalent incentive contracts and concludes that participants exert more effort when assigned to combination contract of reward & punishment incentives compared to a pure reward or pure punishment contract. Therefore, framing of incentives has advantages (Brink, 2008). Armantier and Boly (2015) also measured effort levels of participants. They found that no incentives had the lowest effort level, followed by pure bonus, pure punishment and the effort level was highest with combined incentives of reward & punishment. Those results are significant and robust for different cultural characteristics.

Concerning quality, a study in a piece-rate setting with target levels is carried out by Armantier and Boly (2015). One of the main findings is that participants facing a combination of rewards & punishment incentives had the highest quality of the task they had to perform compared to the other treatment groups.

A combination contract with reward & punishment incentives has some downsides. It could become costly like Armantier and Boly (2014) showed. They studied the effect of the combined incentives on the acceptance of a monetary bribe and found that participants who had the combination contract were significantly more likely to accept the bribe and had a lower quality (which was asked for with the monetary bribe) compared to participants with only reward or only punishment incentives.

2.5.4 Limitations existing literature

Disadvantages of most studies is that target levels are used which lead to other/extra incentives compared to the monetary incentives from a piece-rate payment scheme. Also, the combination of reward & punishment incentives is not extensively investigated.

Implicit or explicit targets or standards are used to communicate expected performance levels (Murphy, 2000). Monetary incentives with target levels provide little incentive if an agent believes that he will not achieve this expected level (Merchant and Manzoni, 1989). This is also the case if the target levels are too easy to reach. Not achieving this level is possible due to ability, but also because of uncontrollable factors like recessions. Targets can therefore also generate fraud incentives or laziness, which lead to a low trust culture and performance losses. However, performance targets could influence behaviour positively if the targets are considered in relation to the payment design, goals and environmental conditions of an organisation (Franco-Santos & Bourne, 2008). Therefore, target levels trigger a trade of between working hard and working smart (Fang, Palmatier, & Evans, 2004).

The comparison is not clear between the effects of framing on quality and effort using an incentive based piece-rate payment scheme without a guaranteed base pay and without target levels. Therefore, the aim of this experimental study is to identify the effects of framing, and especially of combining reward & punishment incentives, on quality of the tasks that agents face and the effort levels chosen in a piece-rate incentive scheme without target levels or base pay.

2.6 Summary Literature

The previous section of this research, reviewed the existing literature to provide a complete overview of the research problem. It outlines the research that has been done on the topic of framing monetary incentives and the effects on quality and effort. The presented overview is summarised in this part. Starting with the theory and followed by the empirical findings.

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Theory

It is important to understand agents‘ motivations in order to be able to influence them in a favourable way for an organisation. In the standard (simple) model of agency theory, introducing extrinsic incentives cannot lower effort levels chosen by the agent. However, behavioural theorists argue that monetary incentives are not an effective motivator because intrinsic motivation for a task will be affected negatively by giving extrinsic incentives.

Organisations and agents use contracts to agree on monetary incentives. According to agency theory, only the performance-dependent part of the compensation has an incentive effect and drives the agent‘s decisions. If only a fixed wage is offered, an agent should exert the lowest effort possible. Piece-rate contracts can be framed in economically equivalent settings. Standard principal-agent theory predicts the same behaviour of agents for the economically equivalent monetary incentives; therefore behaviour is independent of framing. Behavioural theorists suggest that framing alters our understanding of the setting. Therefore, rewards and punishments have different effects on behaviour which leads to differences in quality and effort.

Empirical findings

Concerning motivation, psychologists found evidence for intrinsic motivation. Monetary incentives significantly undermine free choice intrinsic motivation and self-reported interest. In a fixed wage contract setting, higher wages and higher effort levels are observed compared to standard theory.

The focus of existing literature on framing is often on effort with the use of target levels, keeping quality unchanged. The switch from fixed wage to a piece-rate with Rewarding incentives will have a positive effect on effort. This is only the case if tasks are easy, not ability challenging and when targets are clearly defined. Agents are incentivised to cut back on quality.

Punishment incentives improve effort compared to a fixed wage contract. Quality in a punishment contract is higher than in a reward framing. A punishment framing may be perceived as unfair and controlling and therefore triggers a decrease in effort and quality. However, loss-aversion might increase effort and quality.

Rewards and punishment can act as complements. A reward can provide an incentive to desired behaviour in one dimension while punishment can prevent undesired behaviour in another dimension. Studies conclude that quality and effort increases, when participants changed from a fixed wage to piece-rate incentives. Reward & punishment incentives also increased effort and quality compared to pure rewards or pure punishment incentives. However, a combination contract with reward & punishment incentives could become costly for the organisation, due to fraud incentives

Overall, studies found that quality choice and effort provision are sensitive to incentive framing because of different motivational implications, this is in contrast to the predictions of standard agent theory. Disadvantages of most studies is that target levels are used which lead to other/extra incentives compared to the monetary incentives from the piece-rate payment scheme. Therefore, the aim of this experimental study is to identify the

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3. Experimental design & procedures

This section discusses the experimental design and the procedures during the experiment to facilitate the replication of this study. The aim of this experimental study is to identify the effects of framing and especially, combining reward & punishment incentives, on quality of the task the agent faces and the effort levels chosen in a framed piece-rate payment scheme without target levels. First the experimental design will be discussed, followed by the definitions. Paragraph 3 presents the payment scheme designs. The procedures will also be discussed. This section concludes with a short summary.

3.1 Design

This research operationalizes the research question with the use of an experiment combining a between-subject design and a within-subject design. This experiment was held with first-year Economics and Business BSc. students of the University of Amsterdam. The effects of incentives on effort and quality can be reasonably isolated through an experimental design because of de possible control of all the other explanatory variables. This increases the internal validity.

Low task complexity is desirable to study quality for two reasons. First, monetary incentives cause worse performance if cognitive sophistication and open-ended thinking are required (Kohn, 1993). Second, a lack of concentration and motivation in easy tasks can be compensated by monetary incentives, while a lack of skill (ability constraint) in difficult tasks cannot (Bonner, et al. 2000). A math or IQ task could be challenging and also test for knowledge and ability instead of motivation.

A task which is not challenging the ability of a participant is a grid task (Lezzi, Fleming & Zizzo, 2015). The use of a grid task will increase the construct validity because motivation and concentration are measured instead of ability. Therefore it is possible to measure the causal effect of monetary incentives trough concentration and motivation on quality and effort which increases the internal validity. Hence, this experiment uses a grid task with 60 matrices of 5x6 boxes filled with random 1‘s and 0‘s. The participants are asked to count the amount of 1‘s in each of the matrices. The questions are easily solvable, if enough time is taken to solve it. The time constraint to complete all the tasks is 3 minutes.

This experiment consists of nine sessions with three rounds each. In the first and second round, the participants are asked to complete a real effort task. The last round consists of a non-incentivised questionnaire. Brügen & Strobel (2007) analysed different ways of operationalizing effort in experiments; real effort and chosen effort. Their results support equivalence between chosen effort and real effort. Therefore, in this research, both real effort and chosen effort will be used, which should not influence the results according to Brügen & Strobel (2007).

An example of a task: 1 1 0 1 1 0 1 0 0 1 1 1 1 1 1 0 0 0 0 0 Answer = 17 0 1 1 0 1 0 1 1 1 0

Table 1: Overview of experimental timing

Round

Description of the round

Control round

Treatment round

Questionnaire

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Three different research treatments will be implemented. The differences in treatments become clear in the framing of incentives given for the task, like different organisations setting different incentive schemes. The expected pay-off in each round will be the same. And the exact payoff in each treatment is exactly the same for the same performance, so the difference in treatments is pure framing. It is, therefore, possible to analyse a causal relationship between framing and quality or effort.

Round 1 is the control round in which every participant takes part. The participant gets a fixed fee of 60 points for completing the task. This fee is not conditional on any measure of performance. There are two reasons for implementing this round. First, the information gathered in this round allows this research to compare participants‘ performance receiving a fixed fee to their own performance based on a piece-rate payment scheme. So the pure reaction to different incentives could be isolated with the use of a within comparison. In addition, the performance of all groups can be compared to see if they perform equally well on the same test in the same conditions. If the different groups perform equally well, the results from the different treatments can be compared with the use of a between comparison.

Round 2 for each session consists of one of the following treatments. Reward treatment, the participants are told that they receive 2 points for every correct answer. Punishment treatment, participants receive 120 points endowment and for every incorrect or incomplete question 2 points will be reduced from the endowment. The reward & punishment treatment, participants receive 60 points. This will be increased by 1 point for every correct answer and the total will be reduced by 1 point for every incorrect or incomplete answer. This third treatment takes most of all treatments the informativeness principle and equal compensation principle into account. Those principles state that any measure of performance that reveals information about a chosen effort/quality level should be included in the payment contracts of agents, and those activities which are equally valued by the organisation should be equally valuable for the agent in a multitasking environment. Both correct and incorrect answers reveal information which is used for payment and the objectives of the firm. The participants of the different sessions aren‘t aware of the different treatment.

The final part of the experiment consists of a questionnaire with 3 parts. This is used for the collection of control variables and to determine possible selection effects. Part 1 considers background information of gender, age and average high school exam grade. There are also self-reported questions about the level of concentration and motivation. Part 2 consist of questions concerning selection effects and the perception of the framing of

Table 2: Overview of experimental Design

Description

Session

# Participants

Reward

62

Punishment

60

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to indicate if further research is needed. Part 3 consists of a scaled- up version of a Holt & Laury (2002) risk preference decision table. The purpose of this test is to give a non-incentivised measure of risk preferences of the participants.

This experimental design allows this research to compare relative changes in quality and effort between the different payment schemes. It is possible to analyse a causal relationship between framing and quality or effort

3.1.1 Risk aversion & Loss Aversion

Morrison and Oxoby (2014) provided evidence that loss aversion influences decisions beyond the effects of risk aversion. They run an experiment in which participants could earn money and make choices in a Holt and Laury (2002) risk aversion and a similar loss aversion test with this earned money. The control group participated in the loss aversion test directly after the experiment in which they earned their money. The treatment group was paid the money they earned in cash and had to come back in a week for the loss aversion test; they had to bring the same amount of money as they got as an endowment. Morrison and Oxobey (2014) found that the treatment group made more safe choices in the loss aversion test compared to the control group.

There are practical constraints for my research such as monetary constraints and time constraints. Therefore, it is not possible to replicate the result of Morrison and Oxoby (2014) and use loss aversion data in this research. Hence, only risk aversion results will be used.

3.2 Definitions

This study focuses on quality and effort. There are different definitions of those terms possible; therefore the precise definitions in this real effort experiment are as follows: Quality is defined as the fraction of correct answers given by a participant from the total tasks the participant complete during the test. In this measure, the errors made by a participant are the difference between total task completed and the total of correct answers.

Quality is defined as:

Effort is defined as the fraction of tasks a participant completes from the total tasks that are available during the test. It could also be interpreted as output in this research. This definition requires an assumption which states that completing a task correctly requires as much effort as completing a task incorrectly.

Effort is defined as:

This research uses relative terms to increase the construct validity. Ratios are used to measure quality and effort, because the interpretation of changes in absolute terms is not informative. Relative terms take the size of the effects into account and are unitless numbers, which could be expressed and interpreted as percentages.

3.3 Design of payment scheme

The payment scheme design in this research is based on Lazear (1998). . For the first (control) round, a behavioural based payment scheme will be used, which pays for participation. The parameter of interest in this round is which is positive . For the second round, a linear outcome based

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piece-rate payment scheme will be used. Compensation parameter , , and output measure , are defined in different ways base on the framing setting. In this experiment, all answers to the tasks will be corrected by the experimenter and therefore there is no noisy monitoring measure of output and also no concerns about the monitoring intensity principle, which state that when incentives are high, it is correlated with a high optimal monitoring level.

To design a payment scheme with equal expected payoffs in the different rounds and treatments, a small pilot experiment of 12 participants is held at the University of Amsterdam. From this pilot, a resulted average of 30 tasks was completed correctly by the participants and 2 tasks were answered incorrectly. The payoff schemes of this experiment are based on this pilot to keep the expected payoff of an average participant the same in each treatment. The total amount of tasks in this experiment is 60 (N). In this experiment the incentives are simply framed so participants will understand the payoff schemes they face. The following notation is used:

Table 3 gives an overview of the payment schemes used in this experiment. The treatments are all economically equivalent to each other. Only the framing is different.

Table 3 : Economically Equivalent Payment Scheme Designs (Framing)

Fixed

Fee

Reward

Punishment

Reward&

Punishment

Base pay

# correct

# incorrect

# incomplete

Total

An example of performance and the corresponding payoffs in the different treatments is given in table 4. All the treatments are economically equivalent to each other for the same performance (correct/incorrect).

Table 4: Calculation Example Treatment Payoffs

Example Payoff

(in points)

Fixed

Fee

Reward

Punishment

Reward &

Punishment

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The conversion rate from points to Euro‘s in this experiment is 10 points for 1 Euro. So the corresponding payoff with 30 tasks answered correctly is 60 points and 6 Euro for each round. The experiment is designed to take no more than 30 minutes of a mandatory lecture. The minimum hourly wage of a nineteen-year-old in the Netherlands is 4.70 Euro (Rijksoverheid), so 2.35 Euro for the time of the experiment. The outside option of the participants is 0 euro because the lecture, in which this experiment takes place, is mandatory. The conversion rate in this experiment is chosen to give relatively large incentives to account for the results from Gneezy and Rustichini (2000), who argue that monetary incentives have a decreasing effect on performance compared to not incentivizing at all if the incentives are too low. A student could earn a maximum of 12 Euros which is more than 5 times their minimum wage requirement. The average expected earnings are 2.5 times the minimum wage requirement; this takes the incentive-intensity principle into account.

Some earlier studies used a base pay combined with incentive based piece-rates, other used only incentive based piece-rate payment schemes. This does not result in differences in productivity according to Dickinson and Gillette (1994). Therefore, all payment schemes will be incentive based piece-rate payment schemes without a participation fee to keep this research affordable.

3.4 Procedures

Within the possibilities of running the experiment with first-year BSc. students, it is not possible to randomize participants individually between treatment groups. Every class had to take part in the same treatment. This should not cause problems for randomization because the assignment of students to classes in the beginning of the year is random, only conditional on average high school grade. To control for this, only classes within the same average high school grade group participated in this experiment.

At the beginning of the experiment, the participants are told that the experimental results will be completely anonymous and confidential. Then they are asked if they wanted to take part in the experiment before anything else is explained. After voluntary participation, they take a piece of paper from a bowl with a number on it. This is their participation number which they write down on all the papers they receive in this experiment, this assures anonymity. After this, the experiment starts and any form of communication is not allowed anymore. The instructions are distributed and read out loud in front of the classroom, the instructions also include an example grid. The instructions are written in Dutch, because only native Dutch students will participate in this experiment. There is time for questions after the instructions are finished, the questions are classically answered.

The matrix grid tasks which the participants are asked to answer in this experiment are designed by Microsoft Excel with the use of the random function. This ensures that the level is the same of the tasks in both rounds. Since this research is about quality, incorrect answers are needed to draw conclusions. Therefore the participants face a time limit of three minutes for each round which consists of sixty tasks. After three minutes an alarm goes off and the answer papers are collected immediately. During the task, two teachers are present in front of the classroom to prevent the participants from cheating but not to give the participants a feeling of control.

At the end of the experiment, there will be a payment moment. Since paying the best performing participant could cause participants to take excessive risk, or give other undesirable incentives, this research will randomly select a participant. One of the participants of each session will be randomly selected and paid according to their earnings in

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a randomly selected round. Each participant and each round is evenly likely to be selected for payment. Only one person will be paid to keep this experiment affordable. The random function of Microsoft Excel is used to determine which participant number will be paid.

The general instructions, treatment instructions, tasks, questionnaire, and logbook of this experiment are included in Appendix 1: Experiment.

3.5 Summary

This research operationalizes the research question with the use of a grid experiment combining a between-subject design and a within-subject design. 60 matrices of 5x6 boxes filled with random 1‘s and 0‘s, and the question is to count the amount of 1‘s in each of the matrices. The time constraint to complete all the tasks is 3 minutes.

In the control round, the participant gets a fixed fee of 60 points for completing the task. The treatments are pure framing incentives given in round 2. Reward treatment, receive 2 points for every correct answer. Punishment treatment, receive 120 points endowment and for every incorrect or incomplete question 2 points will be reduced. Reward & punishment treatment, receive 60 points, increased by 1 point for every correct answer and the total will be reduced by 1 point for every incorrect or incomplete answer. All framings are economically equivalent.

The final part of the experiment consists of a questionnaire with 3 parts. Part 1 considers background information. Part 2 consist of questions concerning selection effects and the perception of the framing settings. Part 3 consists of a Holt & Laury (2002) risk preference decision table. There are practical constraints for my research therefore only risk aversion results will be used.

Quality is defined as the fraction of correct answers given by a participant from the total tasks the participant completed during the test. Effort is defined as the fraction of tasks a participant completes from the total tasks that are available during the test.

The conversion rate from points to Euro‘s in this experiment is 10 points for 1 Euro. So the expected payoff with 30 tasks answered correctly is 60 points and 6 Euro for each round. Only one person is randomly selected for payment. All payment schemes will be incentive based piece-rate payment schemes without target levels or a participation fee.

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4. Hypotheses

The hypotheses of this research are formulated according to standard economic theory, behavioural theory and the results of the previously described studies.

Standard agency theory predicts the same quality and effort level for economically equivalent contracts. So framing should have no effect. Behavioural theory argues that framing alters our understanding of the setting. It sets reference points which are either a gain or a loss. The framing of a problem may influence individual behaviour.

Existing literature states that rewards stimulate agents to exert too much effort which leads to high output levels of low quality. A punishment framing may be perceived as unfair and controlling and therefore triggers a decrease in effort and quality. However, loss-aversion might increase effort and quality in a punishment setting. When combining reward & punishment incentives, a reward can provide an incentive to desired behaviour in one dimension (effort) while punishment can prevent undesired behaviour in another dimension (low quality). Reward & punishment incentives combine the advantages and disadvantages of the separate incentives.

Disadvantages of most studies about framing is the use of target levels which lead to other/extra incentives compared to the monetary incentives from the piece-rate payment scheme. The comparison is not clear on the effects of framing of piece-rate contracts without a guaranteed base pay, controlling for quality and without target levels.

Therefore the hypotheses for this study are formulated based upon standard theory, behavioural theory and existing literature. This leads to the following hypotheses presented in table 5:

Table 5: Hypotheses Framing

Hypothesis 1:

Quality

H0

Framing of piece-rate contracts has no effect on quality

H1

Quality will be different in all framing settings

Hypothesis 1:

Effort

H0

Framing of piece-rate contracts has no effect on effort

H1

Effort will be different in all framing settings

Standard agency theory also predicts that only the performance-dependent part of the compensation has an incentive effect and drives the agent‘s decisions. Hence, a fixed wage should not influence the decisions of an individual. If only a fixed wage is offered, an agent should exert lowest effort possible, which leads to lowest quality. However, agents could be intrinsically motivated which leads to higher actual quality and effort levels chosen by the agents.

Following standard agency theory, a piece-rate incentive scheme should lead to higher quality and effort levels compared to fixed wage contracts. However, studies show different findings. The switch from fixed wage to a piece-rate with rewarding incentives will have a positive effect on effort, but only if tasks are easy, not ability challenging. This is the case in this experiment. But rewards incentivise agents to cut back on quality. For punishments this is the other way around, punishments incentivise agents to increase quality and decrease effort. So the effects of framing could be different when changing from a fixed wage contract to a framed piece-rate payment scheme.

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This leads to the following hypotheses, presented in table 6:

Table 6: Hypotheses Fixed Wage to Framed Piece-Rate

Hypothesis 2:

Quality

H0

Quality will not change, when switching from a fixed wage

contract to a framed piece-rate contract

H1

Quality will change, when switching from a fixed wage

contract to a framed piece-rate contract.

Hypothesis 2:

Effort

H0

Effort will not change, when switching from a fixed wage

contract to a framed piece-rate contract

H1

Effort will change, when switching from a fixed wage

contract to a framed piece-rate contract

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5. Experimental Results

This section presents the results of the experiment in this research. First, the data set will be discussed with the background characteristics of the participants. In section 2 the results of the control round are presented. Section 3 discusses the results of the treatment round. The difference between the control round and the treatment round will be presented in section 4. This section concludes with a summary of the experimental results.

5.1 Data

This experiment consists of 9 sessions with 364 observations corresponding to 182 first-year Economic & Business BSc. students of the University of Amsterdam. The sample consists of 125 males and 57 females. The sessions took place from 10 April 2017 until 13 April 2017. The data includes various self-reported personal characteristics of the subjects, including their gender, age, motivation, concentration level, and risk attitude. No observations are deleted since no measurement errors are detected.

A precise overview of the background characteristics of the participants in each treatment group and the accumulated total values are summarized in table 7.

Table 7: Background Characteristics

All participants

Reward

group

Punishment

group

Reward&

Punishment

group

Age

19.68

19.53

19.57

19.93

(1.56) (1.55) (1.31) (1.76)

Male

68.68%

67.74%

68.33%

70.00%

Average high

school exam grade

6.60

6.63

6.64

6.51

(0.47) (0.64) (0.42) (0.57)

Motivation

3.37

3.45

3.2

3.47

(0.82) (0.8) (0.86) (0.79)

Concentration

3.41

3.52

3.33

3.48

(0.9) (0.84) (0.88) (0.98)

Risk aversion

5.38

5.58

5.41

5.14

(1.47) (1.52) (1.4) (1.48)

Observations

182

62

60

60

Note: Standard deviation reported in parenthesis

The distributions of the data variables are checked with histograms, see Appendix 2.1. Not all variables showed a normal distribution. To test for normality, skewness and kurtosis tests are performed, together with a joint skewness and kurtosis test for normality. The test results are reported in Appendix 2.2. The variables age, grade, and concentration are significantly different from a normal distribution at the 5 percent significance level.

To check for statistically significant differences in background characteristics between the treatment groups, a series of nonparametric (Mann-Whitney / Wilcoxon) rank-sum tests are conducted. This test evaluates the difference between two groups to check if they follow from the same distribution using ranks. The results are reported in Appendix 2.3. There are no significant differences between the participants in the different treatment groups at a 5 percent significance level. There can be concluded that the different groups are balanced, and that there is no signal of failed randomization.

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5.2 Control round

All participants took part in the first round of this experiment and they all faced the same incentives in this round. More precisely, they face a fixed fee payment scheme. The results of the first round are presented in this section.

Recall the definitions; the quality level is defined as the percentage of questions the participants correctly answered over the total tasks they completed. The effort level of participants is defined as the percentage of total tasks completed over total tasks available. The earnings are the payoff in Euro‘s which the participants earned in the experiment.

An overview of the results of the participants of each group and the accumulated total values are summarized in table 8. The results concerning quality are presented in graph 1, and the results for effort are presented in graph 2.

Table 8: Results Control Treatment

All participants

Reward

group

Punishment

group

Reward &

Punishment group

Quality (%)

89.51

88.18

90.08

90.32

(8.6) (8.56) (8.8) (8.4)

Effort (%)

41.69

41.21

41.53

42.36

(8.27) (8.83) (7.53) (8.49)

Earnings (€)

6

6

6

6

- - - -

Observations

182

62

60

60

Note: Standard deviation reported in parenthesis

Graph 1: Quality Control round The results indicate that the quality level is 89.51 percent on average in a fixed fee setting and the effort level is 41.69 percent on average, with 182 observations. The reward & punishment group had the highest quality level, followed by the punishment group and the quality was lowest in the reward group. For effort, the group with combined incentives has the highest effort level, followed by the punishment group and the lowest effort level is reached in the reward group. The earnings are in all settings fixed at 6 Euro and therefore not shown graphically. To test if those differences are significant, statistical tests are needed. The distributions of the variables are checked with histograms, see Appendix 3.1. The test results of the normality check are reported in Graph 2: Effort Control round

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To check for statistically significant differences in quality and effort of the participants between the treatment groups in the control round, a series of nonparametric (Mann-Whitney / Wilcoxon) rank-sum tests are conducted. The p-values of the test results are reported in table 9.

Table 9: Mann-Whitney / Wilcoxon test:

Treatment Groups in Control Round

Quality

Punishment

p=0.1046

Reward

Punishment

-

Reward&Punishment

p=0.1165

p=0.9559

Effort

Punishment

p=0.6477

-

Reward&Punishment

p=0.3244

p=0.5467

From table 9 can be concluded that there are no statistical differences in quality or effort at a significance level of 5 percent, between the treatment groups in the control round (p > 0.05). These results also show that the quality and effort levels are significantly higher than zero (p=0.000). This indicates that there is evidence of intrinsic motivation which is in contrast with standard economic theory which predicts the lowest effort and quality levels possible when facing fixed wages.

Concluding, the treatment groups do not perform statistically significant from each other on quality or effort if they face the same incentives. Therefore a comparison between the treatment groups can be made if they face framed piece-rate incentive schemes.

5.3 Treatment Results

In the second round, the participants are divided into three treatment groups. Those groups all faced framed, economically equivalent, piece-rate payment scheme. The results of the treatment round are presented in this section.

An overview of the results of quality, effort and earnings of the participants of each framing group in the treatment round and the average results of the control round are summarized in table 10.

Table 10: Treatment results

Fixed Fee

Average

Reward

Group

Punishment

group

Reward &

Punishment

group

Quality (%)

89.51

90.43

91.68

92.28

(8.6) (10.22) (6.98) (6.07)

Effort (%)

41.69

46.77

45.92

46.61

(8.27) (11.36) (8.97) (10.02)

Earnings (€)

6

5.08

5.07

5.17

- (1.31) (1.15) (1.19)

Observations

182

62

60

60

Note: Standard deviation reported in parenthesis

The results of the treatment round presented in table 10 about quality, effort and the corresponding earnings are visually presented in graph 3 until 5, respectively.

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Graph 3: Quality in Treatments

The results indicate that the quality level is lowest in the fixed fee (control) treatment (89.5%) followed by reward treatment (90.4%) and punishment treatment (91.7%) and it is highest in the reward & punishment treatment (92.3%). This is in line with H1 of hypothesis 1 on quality of this research.

Graph 4: Effort in Treatments

The results indicate that the effort level is lowest in the fixed fee (control) treatment (41.7%) followed by punishment treatment (45.9%) and reward & punishment Treatment (46.6%) and it is highest in the reward treatment (46.8%). This result is in line with the H1 of hypothesis 1 on effort of this research

.

Graph 5: Earnings in Treatments

The average earnings are lowest in the punishment treatment (5.07 Euro), followed by reward treatment (5.08 Euro) and reward & punishment treatment (5.17 Euro). The earnings are highest in the fixed fee (control) round (6 Euro).

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