Dynamic Interaction and (In)effectiveness of Financial Incentives

Abstract

This article studies the effectiveness of financial incentives in a simple model in which a team of rational agents works on a joint project. We show that project success may become less likely and agents can be worse off if they face higher rewards. These success and payoff reversals arise naturally in dynamic settings. The underlying mechanism is that dynamic interaction undermines the effectiveness of incentives: while stronger incentives raise agents' efforts within a period, they also discourage efforts in preceding periods. Our findings contribute to a better theoretical understanding of the prevailing empirical patterns of project delays and failures.

Keywords: Financial Incentives, Dynamic Interaction, Team Production, Discouragement Effect, Success Reversal, Payoff Reversal.

JEL Classification: C73, D82, J30, M52