Specific Knowledge and Performance Measurement

I examine optimal incentives, performance measurement and delegation in a model where an agent has specific knowledge (in the sense of Jensen and Meckling) about the consequences of his actions for the principal. Incentive contracts can be based both on measures closely related to the agent's actions ("inputs"), and a measure closely related to the principal's payoff ("output"). While input-based pay minimizes the agent's income risk, only output-based pay encourages the agent to use his knowledge in choosing his actions. To balance these objectives, it is in general optimal to use both performance measures. The results of the analysis provide a common explanation for why central predictions of agency theory, notably predictions implied by the Informativeness Principle, are often not supported by evidence. Moreover, they lead to many novel and testable predictions about properties of incentive contracts and optimal delegation decisions.

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