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The 'Ratchet Principle' and Performance Incentives

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  • M. Weitzman

Abstract

The use of current performance as a partial basis for setting future targets is an almost universal feature of economic planning. This "ratchet principle," as it is sometimes called, creates a dynamic incentive problem for the enterprise. Higher rewards from better current performance must be weighed against the future assignment of more ambitious targets. In this paper I formulate the problem of the enterprise as a multiperiod stochastic optimization model incorporating an explicit feedback mechanism for target setting. I show that an optimal solution is easily characterized, and that the incentive effects of the ratchet principle can be fully analyzed in simple economic terms.

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Bibliographic Info

Paper provided by Massachusetts Institute of Technology (MIT), Department of Economics in its series Working papers with number 239.

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Date of creation: May 1979
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Handle: RePEc:mit:worpap:239

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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), DEPARTMENT OF ECONOMICS, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
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