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Subjective Performance Measures in Optimal Incentive Contracts

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  • George Baker
  • Robert Gibbons
  • Kevin J. Murphy

Abstract

Objective measures of performance are seldom perfect. In response, incentive contracts often include important subjective components that mitigate incentive distortions caused by imperfect objective measures. This paper explores the combined use of subjective and objective performance measures in (respectively) implicit and explicit incentive contracts. Naturally, objective and subjective measures often are substitutes, sometimes strikingly so: we show that if objective measures are sufficiently close to perfect then no implicit contracts are feasible (because the firm's fallback position after reneging on an implicit contact is too attractive). We also show, however, that objective and subjective measures can reinforce each other: if objective measures become more accurate then in some circumstances the optimal contract puts more weight on subjective measures (because the improved objective measures increase the value of the ongoing relationship, and so reduce the firm's incentive to renege). We also analyze the use of subjective weights on objective performance measures, and provide case-study evidence consistent with our analyses.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4480.

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Date of creation: Sep 1993
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Publication status: published as Quarterly Journal of Economics, Vo. 109, No. 4, 1994, pp. 1125-1156.
Handle: RePEc:nbr:nberwo:4480

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  1. Robert Gibbons, 1986. "Piece-Rate Incentive Schemes," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 424, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Baker, George P, 1992. "Incentive Contracts and Performance Measurement," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(3), pages 598-614, June.
  3. MacLeod, W Bentley & Malcomson, James M, 1989. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment," Econometrica, Econometric Society, Econometric Society, vol. 57(2), pages 447-80, March.
  4. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, American Economic Association, vol. 74(3), pages 433-44, June.
  5. Bull, Clive, 1987. "The Existence of Self-Enforcing Implicit Contracts," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(1), pages 147-59, February.
  6. Klein, Benjamin & Leffler, Keith B, 1981. "The Role of Market Forces in Assuring Contractual Performance," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 89(4), pages 615-41, August.
  7. Abreu, Dilip, 1988. "On the Theory of Infinitely Repeated Games with Discounting," Econometrica, Econometric Society, Econometric Society, vol. 56(2), pages 383-96, March.
  8. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  9. Gary S. Becker & George J. Stigler, 1974. "Law Enforcement, Malfeasance, and Compensation of Enforcers," The Journal of Legal Studies, University of Chicago Press, University of Chicago Press, vol. 3(1), pages 1-18, January.
  10. Michael Waldman, 1983. "Job Assignments, Signalling nad Efficiency," UCLA Economics Working Papers, UCLA Department of Economics 286, UCLA Department of Economics.
  11. Prendergast, Canice, 1993. "The Role of Promotion in Inducing Specific Human Capital Acquisition," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 108(2), pages 523-34, May.
  12. Kahn, Charles & Huberman, Gur, 1988. "Two-sided Uncertainty and "Up-or-Out" Contracts," Journal of Labor Economics, University of Chicago Press, University of Chicago Press, vol. 6(4), pages 423-44, October.
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