When high-powered incentive contracts reduceperformance: Choking under pressure as a screening device

Empirical and experimental papers nd that high-powered incentives may re-duce performance rather than improve it; a phenomenon referred to as "chokingunder pressure". We show that competition for high ability workers neverthelessleads rms to oer high bonus payments, thereby deliberately accepting pressure-induced performance reductions. Bonus payments allow for a separating equilibriumin which only high ability workers choose high-powered incentive contracts. Lowability workers receive xed payments and produce their maximum output which,however, is still below the reduced output of high ability workers. Bonus paymentslead to a social loss which is increasing in the degree of competition. Our paperhelps to explain why steep incentive schemes are persistent in highly-competitive industries such as investment banking, and why the observed performance sensitivityof CEO compensation is largely heterogeneous.