Market competition and the effectiveness of incentive pay

It is well-established that the effectiveness of pay-for-performance (PfP) schemes depends on employee- and organization-specific factors. However, less is known about the role of external forces. Investigating the role of market competition on the effectiveness of PfP, we theorize that there are two counteracting effects – business stealing and competitor response – that jointly generate an inverted U-shape relationship between PfP effectiveness and competition. Weak competition discourages effort response to PfP because there is little extra market to gain, while strong competition creates low incentives because competitors are more likely to respond. PfP hence has the strongest effect under moderate competition. Field data from a bakery chain and its competitive environment confirm our theory, allow us to empirically separate the business stealing and competitor response effects, and refute alternative explanations.