Optimism and Contract Selection: Implications for Fixed versus Variable Compensation

Firms often provide rank and file employees with various forms of variable compensation (e.g., stock options, restricted stock units, profit sharing plans, etc.), even though it can be difficult to explain these compensation packages using standard economic theory. In this paper, we shed some light on this puzzle by reporting the results of an experiment that examines how the design of employee compensation packages can affect the type of employee a firm hires. More specifically, we offer theory and evidence that employees who score high on dispositional optimism are more likely to prefer variable compensation over fixed compensation with a similar expected value. Interestingly, and in contrast to traditional economic models, our findings reveal that measures of risk have little explanatory power with respect to contract selection. Lastly, we find that optimism is positively associated with subsequent performance on an effortful task. In addition to contributing to our understanding of how rank and file employees might respond to variable compensation packages, our results also provide insight into recent archival research on optimism and economic behavior.