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Effective utility functions induced by organizational target-based incentives

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Author Info
Ali E. Abbas (Department of Industrial and Enterprise Systems Engineering, College of Engineering, University of Illinois at Urbana-Champaign, Urbana, IL, USA)
James E. Matheson (SmartOrg, Inc., Menlo Park, Stanford University, CA, USA)
Robert F. Bordley (GM Technical Fellow, GM Research Labs, Warren, Detroit, MI, USA)
Abstract

Many companies set performance targets for their divisions to decentralize the decision-making process and communicate with outside investors. This paper analyzes the effects of performance targets on the decision-making behavior of the divisions. We introduce the notion of an 'effective utility function'-a function that a division should use in its selection of projects if it wishes to maximize the probability of achieving its targets. We show that many target-based incentives induce S-shaped utility functions and discuss the organizational problems they may pose. We then show how an organization can set targets that induce expected utility maximization. Copyright © 2008 John Wiley & Sons, Ltd.

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File URL: http://hdl.handle.net/10.1002/mde.1448
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Article provided by John Wiley & Sons, Ltd. in its journal Managerial and Decision Economics.

Volume (Year): 30 (2009)
Issue (Month): 4 ()
Pages: 235-251
Download reference. The following formats are available: HTML (with abstract), plain text (with abstract), BibTeX, RIS (EndNote, RefMan, ProCite), ReDIF
Handle: RePEc:wly:mgtdec:v:30:y:2009:i:4:p:235-251

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Web page: http://www3.interscience.wiley.com/cgi-bin/jhome/7976

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  1. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, vol. 63(2), pages 134-39, May. [Downloadable!] (restricted)
  2. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
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  3. Ali E. Abbas & James E. Matheson, 2005. "Normative target-based decision making," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 26(6), pages 373-385. [Downloadable!]
  4. Brown, Keith C & Harlow, W V & Starks, Laura T, 1996. " Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry," Journal of Finance, American Finance Association, vol. 51(1), pages 85-110, March. [Downloadable!] (restricted)
  5. Robert Bordley & Marco LiCalzi, 2000. "Decision analysis using targets instead of utility functions," Decisions in Economics and Finance, Springer, vol. 23(1), pages 53-74. [Downloadable!] (restricted)
  6. Purkayastha, Sumitra, 1998. "Simple proofs of two results on convolutions of unimodal distributions," Statistics & Probability Letters, Elsevier, vol. 39(2), pages 97-100, August. [Downloadable!] (restricted)
  7. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January. [Downloadable!] (restricted)
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