The tenuous relationship between effort and performance pay

• We consider a model with exogenous variations in contract enforcement.
• We examine how variations in enforcement affect effort and incentives.
• Weaker contract enforcement may lead to higher-powered incentive contracts.
• Effort and performance pay may be negatively related.
• One may wrongfully infer that monetary incentives crowd out non-monetary motivation.

When an agent is offered performance related pay, the incentive effect is not only determined by the shape of the incentive contract, but also by the probability of contract enforcement. We show that weaker enforcement may reduce the agent's effort, but lead to higher-powered incentive contracts. This creates a seemingly negative relationship between effort and performance pay.