Performance Thresholds, Effort and Risk-Taking

We develop a theory and perform an experiment to study the effect of performance thresholds on effort and risk-taking in economic decisions. We find that effort unambiguously increases compared to the ``status quo" level, but that optimal effort varies non monotonically with the threshold level. The effect of a threshold on risk-taking in instead ambiguous, as risk taking increases for thresholds of intermediate levels, and decreases otherwise. The reason for this pattern is that, as the threshold level increases, risk-taking and effort provision shift from being complements to substitutes in the agents' optimal choice. The experiment confirms these insights, and highlights the importance of preference heterogeneity. The introduction of a threshold can induce some agents (who perceive the level as either low or high) to substantially increase effort and decrease risk taking, while others increase risk-taking as a result. Overall, our results highlight the potential but also the pitfalls of using thresholds to create incentives. Effective design of a threshold scheme requires both awareness of the differential impact the threshold has on effort and risk-taking and a good understanding of the preference heterogeneities in the population