The Royal Swedish Academy of Sciences announced the winners of the Nobel Prize in Economic Sciences on Monday. The awardees, Oliver Hart and Bengt Holström, were responsible for making major advances in how economists understand contracts. Some of Holmström’s earliest work is particularly insightful when considering how your pay contract is structured. In the model, employees like income but dislike risk (meaning income could be higher or lower depending on factors partially outside the employee’s control). The owner of the business has an appetite for the risk, but wants to ensure that the employee is working which can be hard to monitor. By tying compensation to performance, the employer can ensure the employee has the incentive to work hard. This tension between risk and incentives determines how much of a manager’s or executive’s pay is salary and how much is variable based on individual, team, or company performance.
The same insight explains why insurance contracts have fixed deductibles before your policy kicks in and pays a claim. In that case, your insurance company wants to encourage you to avoid dangerous behavior by driving safely, so there’s a base amount you have to pay in the event of an accident. This mixture of fixed and variable payouts follows the same logic, but works in opposite directions – your employer uses the mix to encourage positive behavior that hopefully leads to better economic, while your car insurance mixes to discourage potentially damaging behavior.