Heterogeneity in the Sensitivity to Dynamic Incentives

Project Start: 01/2018
Status: Completed
Researchers: Florian Hett, Felix Schmidt
Category: Household Finance
Funded by: LOEWE

Topic and Objectives

Recent research suggests that herding behavior of individual investors can be a source of amplified volatility in financial markets and hence partially explain their inherent instability. Investigating the role of peer effects in financial decision making, i.e. how financial decisions are affected by the behavior of socially connected individuals, has therefore recently become an active field of research in behavioral finance.

Given the extensive evidence on the general existence of peer effects in other settings, it is arguably not the key issue to show that peers affect financial decisions but rather to explore the actual mechanisms underlying these phenomena. One particular relevant mechanism through which peer effects can unfold are rank incentives, i.e. benefits based on relative as compared to absolute performance. While in many aspects of financial markets such rank incentives can be elements of compensation schemes or implicitly matter through career concerns, evidence from behavioral economics suggests that individuals also have a strong intrinsic motivation to perform well in relative terms.

In this project, we explicitly investigate the heterogeneity of the strength of such intrinsically driven rank incentives that is the sensitivity to relative performance feedback. In particular, we study whether this sensitivity is an individual-specific trait rather than a mere contextual artefact. Put differently, we ask whether there are certain types of individuals that are fundamentally more prone to be affected by peer behavior than others. We conduct laboratory experiments in order to identify the relation between individual characteristics and behavior in dynamic contest environments

Key Findings

  • Feedback does affect effort within a particular contest. We find that the information to currently occupy a better rank on average leads to more effort and vice versa. Feedback effects even spill over to subsequent contests with new competitors. 
  • The results appear reasonable and statistically robust. However, aggregated patterns mask a profound degree of heterogeneity.
  • The strength of the effect of rank feedback varies substantially between subjects. Also, the direction of the effect of rank feedback varies considerably.
  • Individuals that react positively to a better rank (and therefore negatively to a worse rank) win fewer and lose more contests and achieve overall worse outcomes.
  • We find very low correlations of a rank sensitivity and other common individual characteristics (i.e. competitiveness, ability, risk aversion, and other-regarding preferences). The result gives rise to the idea that rank sensitivity is an idiosyncratic individual trait.

Policy Implications

  • Institutional frameworks often have competitive and fundamentally dynamic aspects including intermediate feedback on relative performance. If individuals differ in their reaction to this intermediate feedback, this implies non-trivial allocative and distributional effects on final outcomes, as initial differences might either be amplified or dampened for different individuals.
  • Variations in competitive design then potentially shift individual outcomes not only with respect to obvious characteristics like ability, but also with respect to feedback sensitivity.
  • Evidence regarding heterogeneity in the reaction to rank feedback might help in assessing a broad variety of institutional rules like relative grading in schools or peer evaluations in organizations.

Related Working Papers

No. Author/s Title Year Research Area Keywords
203 Florian Hett, Felix Schmidt Pushing Through or Slacking Off? Heterogeneity in the Reaction to Rank Feedback 2018 Household Finance heterogeneity, competitiveness; contest; rank feedback, relative performance evaluation

 

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