Performance Pay,Productivity and Morale*

This paper incorporates the notion of worker morale into an economic model of pay and performance, and examines its implications for the efficacy and design of performance-based pay schemes. A worker's morale is determined by his relative pay status. A contract that rewards only individual performance can therefore undermine the morale of the least skilled workers in a firm and thereby adversely affect their productivity. On the other hand, competition for relative pay status tends to boost the productivity of highly skilled workers in the firm. The net effect on productivity depends on the composition of the firm's workforce. If the workforce is sufficiently heterogeneous then the inclusion of a profit-sharing component in the pay contract, which reduces the pay differential across workers, can sufficiently boost the morale of the least skilled workers as to improve overall productivity and profitability.