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Ambiguity sharing and the lack of relative performance evaluation

Author

Listed:
  • Yaoyao Wu

    (Shanghai University of Finance and Economics)

  • Jinqiang Yang

    (Shanghai University of Finance and Economics)

  • Zhentao Zou

    (Shanghai University of Finance and Economics)

Abstract

We extend the Holmstrom and Milgrom (Econometrica 55:303–328, 1987) model by introducing model uncertainty to study robust long-term contracting and focus on relative performance evaluation. Concerns regarding model misspecification induce a tradeoff between incentives and ambiguity sharing, which increases the pay-performance sensitivity. When compensation contracts can be written on some additional signal, such as industry average performance, we find that an ambiguity-averse principal increases the agent’s exposure to the common shock by reducing the use of relative performance evaluation. Thus, optimal contracting involves effectively paying for luck and our model provides a theoretical explanation for the well-documented lack of relative performance evaluation in CEO compensation from the perspective of model uncertainty.

Suggested Citation

  • Yaoyao Wu & Jinqiang Yang & Zhentao Zou, 2018. "Ambiguity sharing and the lack of relative performance evaluation," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 66(1), pages 141-157, July.
  • Handle: RePEc:spr:joecth:v:66:y:2018:i:1:d:10.1007_s00199-017-1056-x
    DOI: 10.1007/s00199-017-1056-x
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    Cited by:

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    3. Jiajia Chang & Zhijun Hu & Hui Yang, 2020. "Venture Capital Contracting with Ambiguity Sharing and Effort Complementarity Effect," Mathematics, MDPI, vol. 8(1), pages 1-16, January.
    4. Johanna Etner & Meglena Jeleva & Natacha Raffin, 2021. "Climate policy: How to deal with ambiguity?," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 72(1), pages 263-301, July.
    5. Shilin Li & Jinqiang Yang & Siqi Zhao, 2022. "Robust leverage dynamics without commitment," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 74(2), pages 643-679, September.
    6. Niu, Yingjie & Yang, Jinqiang & Zou, Zhentao, 2020. "Robust contracts with one-sided commitment," Journal of Economic Dynamics and Control, Elsevier, vol. 117(C).
    7. Wang, Yuanping & Mu, Congming, 2019. "Can ambiguity about rare disasters explain equity premium puzzle?," Economics Letters, Elsevier, vol. 183(C), pages 1-1.
    8. Farzad Pourbabaee, 2021. "Robust Experimentation in the Continuous Time Bandit Problem," Papers 2104.00102, arXiv.org.
    9. Wu, Wei & Niu, Yingjie & Wu, Yaoyao & Xu, Hongru, 2022. "Ambiguity, limited commitment, and the q theory of investment," The North American Journal of Economics and Finance, Elsevier, vol. 60(C).

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    More about this item

    Keywords

    Relative performance evaluation; Reward for luck; Model uncertainty; Ambiguity sharing;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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