Abstract
This study uses a Monte Carlo simulation to examine how the relationship between pay and performance is affected by the pay system, measurement error in appraising performance, the consistency of true performance over time, and the rules governing promotion decisions. The authors find that conventional merit systems achieve a considerably better link between pay and performance than does a bonus system with periodic adjustments in base wages. A bonus system without periodic base wage adjustments also performs less well than conventional merit systems, because merit systems benefit from the consistency of true performance over time. One surprising finding is that even very substantial error in the measurement of performance has only a modest effect on the pay-performance correlation.
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