Psychology Of Pay And Compensation Research Paper

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1. The Design Of Compensation

In industrialized countries the compensation of managers and employees usually consists of three or four component parts. One part is rooted in the value of the job which is held, providing for the fixed base pay (wage or salary). The second part reflects an assessment of the effort exerted or the performance result, often called the ‘performance bonus.’ The third part deals with ‘secondary labor conditions,’ such as health insurance, retirement provisions, etc. Firms in several countries offer still additional benefits—perquisites—to their personnel (or merely their managers), such as car lease, lower interest rates on mortgage loans, etc. However, there are sizable differences between (and often also within) countries regarding the proportional contribution of each of these parts to an individual’s total compensation.



Yet the common design in the composition of compensation in most countries is remarkable. This cuts across considerable differences between countries in industrial relations, wealth and welfare, and culture. Why? Probably partly because traditions in trades and industrial sectors, laws and regulations, and the ideas of labor unions and employers’ federations are playing a role. And also, in all likelihood, partly because of some widely shared beliefs and attitudes about the differential impact of the various compensation components upon the work behaviors of organization members. This borders on the psychological perspective on pay, which addresses the impact of compensation upon the attitudes and work behaviors of organization members, both individually and as part of teams or larger work units. More particularly, the psychological study of pay and compensation aims to identify determining variables at different levels of analysis (such as pay system, or strength of individual expectations), moderating aspects (such as the nature of the task), and individual, group, or company-wide results (such as performance or productivity).

This perspective determines the design of this research paper. First, the nature of the four compensation components is further described, in relation to some characteristic beliefs and attitudes on how they operate. Next, a few psychological theories on pay and compensation will be discussed. Finally, some implications for psychological research on pay and applications in practice are discussed.

2. Four Components And Concomitant Beliefs

Although the background of the compensation components is discussed in relation to what is characteristically expected regarding each of them, I do not imply that a company’s management is always engaged in decision making along these lines. Indeed, pay systems and compensation provisions may have been introduced in a firm for reasons of tradition, imitation of other companies, or merely because alternative choices were not considered.

2.1 Base Pay

In most countries base pay constitutes the main part of an organization member’s take-home pay. Yet there may be sizable differences in the proportion of base pay between trades and job categories. Traditionally, the pay of sales representatives is determined to a large degree by actually achieved sales figures. Managerial pay is characterized by a proportionally lower base-pay component than nonmanagerial pay, in particular for senior managers (Rynes and Bono 2000). Base or job pay is often set through a system of job evaluation (cf. Thierry and De Jong 1998). Increasingly, international wage and salary surveys are used, as well as more subjective impressions of the going rate on the market. Base-pay levels are usually fixed as long as the term of individual contracts or collective agreements applies.

Often the fixed base-pay level is a reflection of the belief that stability in pay contributes to individual feelings of security. It is also supposed that without the need to worry about their pay, working people will concentrate more upon the content of their tasks. Moreover, a high base-pay level may imply the notion that work motivation is considerably more affected by nonmaterial needs and goals than by material ones. Possibly this results in more intrinsic motivation (cf. Deci and Ryan 1985, Deci et al. 1999). Characteristically, levels of base pay increase each year, usually through an additional ‘step’ on the wage or salary scale. Although the latter increase may have been awarded to make up for increased costs of living, it often also mirrors the idea that more maturity (i.e., getting older and becoming more experienced) goes along with better performance.

2.2 Results-Oriented Pay

This category, also called ‘pay for performance,’ is host to a variety of systems and forms. Results may be derived from individual performance appraisal sessions, in which rather abstract characteristics (such as initiative or creativity) are interpreted and considered. Results may also refer to quantitative outcome scores, for instance the number of new bank clients secured and the volume of their investments. Results may relate to individual data, but also to those of teams, units, and whole organizations (such as sales volume or net profit). These data may be provided weekly, monthly, or over a much longer period. The ‘pay’ is often allocated in the form of a bonus (paid only once), but it may also be given as an extra, ‘structural’ salary increase. The amount of results-oriented pay may be rather modest (e.g., 3 percent), but it may also exceed the base pay’s proportional part of total compensation (see, more extensively, Rynes and Bono 2000, Bartol and Locke 2000, Thierry in press).

What is results-oriented pay supposed to effectuate? A widespread belief holds that it stimulates an individual’s work motivation, effort, or performance. Re- search evidence (Thierry in press) shows that this can be frequently supported, although there are also many instances of failure. Another assumption is that results-oriented pay is perceived by many employees (and managers) as more fair, since it compensates for perceived individual and group differences in effort and or performance (Van Silfhout 2000). Organiztions in which this assumption is endorsed usually assign a particular budget to covering these merit-pay expenses. Making pay dependent upon performance results may be used to cut costs as well. Moreover, it may be used to feed performance data back to employees, and, more generally, for communicating with them.

More than is the case for other compensation components, the phase of preparing and introducing results-oriented pay is rather complicated and time consuming. It may imply that a part of the work flow is being organized more efficiently, that norms and targets are being established, that results are being fed back, that employees and managers are being consulted about the new system, and so forth. In particular, when better performance results have been reached, a point of concern is that these activities may have contributed to these results rather than the linkage between performance and pay.

2.3 Secondary Labor Conditions

There are huge differences between countries in the handling of secondary conditions. Traditionally, companies in the USA offered a very modest package to their members—leaving to them the decision whether or not further to insure themselves—whereas companies in northwestern Europe provide encompassing social security within the framework of collective labor agreements. In the latter case, conditions relate, for example, to health insurance, disability coverage, retirement benefits, or unemployment provisions. These are intended to help working people to compensate for risks they run in their work and lives. Yet, such social security packages are not very well tailored to the individual organization member’s conditions and wishes. Moreover, because of health research and technological innovations, there is a continuing trend to expand the number and the nature of social security provisions.

It is therefore an interesting development that the ‘cafeteria plan’ is gaining popularity on both sides of the Atlantic (Barber and Bretz 2000). According to this plan (also called ‘a la carte’ or ‘flex-pay’) organization members may exchange one or more standard labor conditions for optional ones. In US companies this plan was initiated some 40 years ago, in order to gradually expand social security coverage. Consequently, managers and employees may tailor their social security package to their particular conditions, which may lead to more utility against similar or lower costs for the company. More recent European experience, for instance in the UK and The Netherlands (cf. Thierry 1998), indicates that organizations think the plan equips them better as competitors in the labor market for ‘flexible, employable’ applicants. They may also express their particular culture and climate in their choice of alternative provisions. Consequently, their members are expected to be more motivated, to work better, to be more satisfied with their pay package, and to have more knowledge of their compensation components. Research evidence shows that only the latter two expectations are frequently met (Thierry 1998, in press).

2.4 Perquisites

Organizations may offer their personnel (or selected categories, such as senior managers) still further labor conditions. Early examples came in the manufacturing sector, in which an allowance for occupational clothing or cloth cleaning was sometimes provided. Current practices include (mobile) phone cost coverage, car leasing, lower mortgage interest, shares on the stock market, options on company shares, and so forth. Some of these options may be available through a cafeteria plan (see Sect. 2.3). Perquisites were provided to make up for particular inconvenient conditions and occupational costs, but current objectives relate to attracting potential applicants on the labor market and, in particular, to keeping qualified personnel within an organization.

2.5 Beliefs In Perspective

The preceding overview of compensation components shows that each component is characterized by rather distinct beliefs and expectations about how compensation may affect the attitudes and work behaviors of managers and employees. Yet an important issue is whether these beliefs are founded in concepts relevant to psychological theories on pay and compensation. Some of these will be reviewed here (more extensively in Thierry in press), but the various beliefs are to be recognized in almost all objectives of pay (cf. Thierry 1998):

to attract applicants from the labor market;

to retain qualified personnel within an organization;

to motivate managers and employees to perform well;

to alert managers and employees to engage in different performance behaviors in times of change;

to balance inconvenient working conditions with an attractive award;

to prevent industrial conflicts (or to solve these where they have occurred);

to cut down labor costs; and

to further a distinct, recognizable business unit or group culture.

3. Some Psychological Theories On Pay

Most psychological theories on pay have not been explicitly designed for understanding and predicting people’s behaviors and attitudes regarding pay. Rather, they have been derived from more general theories, for instance regarding motivation. The theories selected here stem from both ‘categories.’

3.1 Expectancy Theory

This theory concerns matters of work motivation (Vroom 1964, Van Eerde and Thierry 1996), in particular the choice process of an employee being faced with the necessity or the opportunity to mark a course of action among alternative activity patterns. Suppose that an employee considers whether to spend all their energy and resources in making the current job a great success, hoping for a promotion in the not too distant future, or whether to apply for a job in another organization, which involves taking several courses in order to become more employable. Expectancy theory holds that three cognitions determine the eventual choice:

the probability that a particular level of effort leads to a specific level of performance;

the probability that this performance level causes the attainment of particular outcomes; and

the attractiveness of those outcomes.

The alternative with the highest subjective utility for the employee will be chosen. Thus, assuming that a job elsewhere is slightly more attractive than a promotion, the employee may nevertheless opt for the internal promotion, since they estimate the probability of getting access to courses that will increase their employability as much lower than turning the current job into a success.

Lawler (1971) has applied the last two cognitions to the importance of pay. Accordingly, its importance to an employee is a function of:

the extent to which pay is perceived as offering resources for satisfying particular needs or goals; and

the importance of these needs and goals to that employee.

In other words, the more pay is considered to be instrumental in getting more security in life (e.g., through purchasing an insurance policy), in being recognized by other people, and in gaining more independence—to mention some examples—and the more these needs are important to the individual employee, the more important pay has become. Pay is not important in itself: it may be a stronger or weaker vehicle for reaching other outcomes.

One implication bears upon the system of results-oriented pay: in order to be effective, it is necessary that an organization member perceives a clear ‘instrumental’ link between one or more particular performance levels and specified amounts of pay (e.g., Van Silfhout 2000).

3.2 Equity Theory

Expectancy theory is focused upon the individual human being, engaged in means-to-end relationships. Is that individual affected by one or more others, by smaller or larger social networks in the choice-making process? Yes, according to Ajzen and Fishbein’s theory of reasoned action (1980), in which the individual’s beliefs about what others think he or she should do are supposed to affect the choices he or she make. Equity theory (Adams 1963, 1965) includes ‘social others’ indirectly in the balance between contributions and inducements. Adams holds that an individual strives for such a balance relative to the balance that individual perceives between contributions and inducements as applying to a referent. A referent may be one or more human beings, a particular group, an organization’s policy, and that individual at an earlier or later stage of their career. Contributions relate to long-term investments and short-term costs, such as education, abilities, and effort. Among inducements are task performance, recognition, and compensation. Equity is achieved when the person’s perceived contributions–inducements ratio is equal to their perception of the referent’s ratio. An unequal balance results in dissonance and inequity.

A typical setting would be an experiment in which the ratio between a person’s effort (to perform a task) and pay is compared with the effort–pay ratio as perceived to apply to the referent. A high level of inequity would be the result when the person perceives their own situation in terms of high effort for low pay, and the referent’s ratio as low effort for high pay. Obviously, the person would then be motivated to restore an equitable balance. But how? That is difficult to predict. Available strategies are: effecting change in contributions and/or inducements; changing the referent; cognitively reinterpreting the inequitable situation; or leaving the organization. Harder (1992) showed in a study of baseball and basketball players that under-rewarded players tended to opt for utilitarian, egotistic behaviors that were thought to lead to future higher rewards.

3.3 Reflection Theory

This theory specifies the meanings of pay or compensation. A basic notion is, again, that pay has no significance in itself, but that it acquires meaning to the extent that it conveys information that is vital to an individual’s self-identity. Accordingly, pay ‘reflects’ information about events in other fields. Four categories of meaning are distinguished:

(a) Motivational properties. This category is derived from expectancy theory (Sect. 3.1). Pay is meaningful to the extent that it is considered to be instrumental in satisfying a person’s motives.

(b) Relative position. This bears upon two aspects. One reflects feedback about task performance relative to the targets set. Pay may signal whether particular corrective actions are necessary. The other aspect is social comparative: pay reflects how well a person is doing in comparison with others inside and/or outside the company.

(c) Control. Pay may reflect the amount of control the individual exerts on their environment (both the social network and material means) as well as the extent to which they are controlled by the environment.

(d) Spending. Here pay reflects the utility of goods and services purchased by the individual, and the ease or hardship with which this occurred.

Scales are available for measuring these meanings. The core of reflection theory is that the more an employee or manager reads meanings into their pay, the more their performance and satisfaction with pay is affected (Thierry 1998, 2001). Obviously, the design of a pay system and the manner in which it is administered are among the variables that influence the meanings pay may have.

4. Conclusion

An important question raised in the introductory section is whether the beliefs and expectations which seem to be basic to the four compensation components are grounded in psychological theories on pay. Just three theories could be discussed; nonetheless, their tenets are rather representative. Expectancy and reflection theory provide some ground for results-oriented pay, in particular regarding the importance of unambiguous performance leading to pay perceptions. Yet it is not clear how these perceptions should be structured in the case of group performance; possibly equity theory’s notion on contribution—inducement ratios should also be considered. The belief embedded in the concept of base pay—that stability and predictability of pay may cause employees and managers to be focused more upon the content of their work—does not take full account of the meanings of pay (put forward in reflection theory) relative to the meanings of nonmaterial work characteristics. This is clearly in need of more research. Continued research on cafeteria plans, including perquisites, is vital, in order to learn whether this compensation component meets its expectations. All in all, however, beliefs and expectations about compensation in practice are not so much missing the point as more outspoken than psychological theory would require them to be.


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