Pay—but do not pay too much: An experimental study on the impact of incentives

Most principal agent models predict that increasing incentives result in higher performance. This paper examines whether this result is valid under real effort conditions. Exposing the participants to varying strengths of incentives, we find an inverse U-shaped relationship between effort levels and incentive intensity, which not only contradicts predictions of standard theory but also observations in previous real effort experiments. We provide a new theoretical explanation for the results within a principal agent model with loss averse agents.