Incentive Contracts and Performance Measurement

This paper examines the characteristics of incentive contracts in which the agent's payoff is not based on the principal's objective. I show that contracts based on such performance measures will not in general provide first-best incentives, even when the agent is risk neutral. The form of the optimal contract and the efficiency of this contract depend on the relationship between the performance measure used and the principal's objective. The model provides a simple and intuitive statistical measure that serves as a metric for the efficiency of a performance measure. Applications to various incentive contracting situations, including the "gaming" of performance measures, the use of revenue-based sales commissions, and relative performance evaluation, are presented.

[1]  C. E. SHANNON,et al.  A mathematical theory of communication , 1948, MOCO.

[2]  G. Veigh.  Pay and Organizational Effectiveness: A Psychological View , 1972 .

[3]  H. Demsetz,et al.  Production, Information Costs, and Economic Organization , 1975, IEEE Engineering Management Review.

[4]  W. Clay Hamner,et al.  How to Ruin Motivation with Pay , 1975 .

[5]  M. C. Jensen,et al.  Harvard Business School; SSRN; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit , 1976 .

[6]  Bengt Holmstrom,et al.  Moral Hazard and Observability , 1979 .

[7]  M. Harris,et al.  Optimal incentive contracts with imperfect information , 1979 .

[8]  David C. Schmittlein,et al.  Integration of the sales force: an empirical examination , 1984 .

[9]  Glenn M. McEvoy,et al.  Managing Human Assets , 1984 .

[10]  William B. Stevenson,et al.  Managerial Compensation Based on Organizational Performance: A Time Series Analysis of the Effects of Merit Pay , 1985 .

[11]  Paul R. Milgrom,et al.  Employment Contracts, Influence Activities, and Efficient Organization Design , 1987, Journal of Political Economy.

[12]  E. Lazear.  Pay Equality and Industrial Politics , 1989, Journal of Political Economy.

[13]  Stefan Reichelstein,et al.  Value of communication in agencies , 1989 .

[14]  Kevin J. Murphy,et al.  Relative Performance Evaluation for Chief Executive Officers , 1989 .

[15]  Edward E. Lawler,et al.  Strategic Pay: Aligning Organizational Strategies and Pay Systems. , 1991 .

[16]  Paul R. Milgrom,et al.  Multitask Principal–Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design , 1991 .