Can second-chance provisions increase the effectiveness of penalty contracts? Evidence from a quasi field experiment

Abstract

Penalty contracts are commonly utilized in developing countries. Such contracts may be perceived as unfair, potentially reducing employee motivation and performance. We predict that adding a second-chance provision, an opportunity to reverse a penalty for poor performance if subsequent performance improves, could improve the effectiveness of penalty contracts. In a quasi field experiment at a company with two manufacturing facilities in Taiwan, we treated one facility with a traditional-penalty contract without a second-chance provision and the other with a penalty contract with a second-chance provision. We observe a significant difference in the two treatment effects, with employee performance decreasing significantly after the traditional-penalty treatment but showing no decrease when a second-chance provision was included. Further analysis reveals that this difference is mediated by employees' fairness perceptions. These results provide valuable insights to governments, nongovernmental organizations, and multinationals as they work together to improve the fairness of global compensation practices.