More on moral hazard in organizations: Reply

The paper by Thomas Hammond and Gary Miller is an insightful comment on the relevance of budget-breaking incentive schemes to real world organizations. They have made a valuable contribution in considering this line of research within a broader context. Nonetheless, they have not established the invalidity of my theoretical arguments. Therefore, my basic point still holds: that is, theoretically it is possible to show that a bonus-penalty incentive scheme of the sort proposed by Holmström is feasible, despite the principal's incentive to cheat. Regardless, all of this debate may beg the question, since compensation arrangements observed in the real world are rarely of the bonus-penalty type. Linear incentives are far more common, and many compensation schemes do not appear to incorporate optimal incentives. At this point we need more empirical research on the determinants of incentives in organizations. In order to make further advances in this area, a better understanding of the incentive mechanisms actually used in organizations is required.Thanks are due to Richard Frank for helpful comments. The usual caveat applies.