Bounded Rationality, Complexity and Optimal Incentives

This paper provides empirical support for the importance of contract complexity, and heterogeneity in worker bounded rationality, for understanding optimal incentives. Specifically, the paper shows that an important aspect of a workplace incentive scheme – dynamic incentives in the form of the so-called ratchet effect – can be a shrouded attribute that some workers neglect due to complexity. In field experiments within a firm, and in online experiments with real effort tasks, many workers make choices consistent with being unaware of dynamic incentives. Changing the contract to make the dynamic incentives more transparent, or looking at the sub-sample of workers with high cognitive ability, a response to dynamic incentives emerges. The results have several implications: a potential optimal degree of complexity; heterogeneous effects of incentives depending on worker cognitive ability; framing and structure of incentives may matter through the channel of complexity; incentive effects may change over time if learning reduces complexity; firms may want to tailor incentives to the cognitive sophistication of their particular workforce.