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Performance Thresholds in Managerial Incentive Contracts

Author

Listed:
  • Xianming Zhou

    (University of Hong Kong)

  • Peter L. Swan

    (University of New South Wales)

Abstract

Performance thresholds are commonly used in executive compensation contracts. We examine the contractual nonlinearity associated with performance thresholds and its incentive implications. Incorporating a performance threshold into a standard principal-agent model of a linear contract, we show that pay schemes using a performance threshold are optimal. By truncating a linear scheme at poor performance, the threshold mitigates agency costs associated with the downside risk of production. Examining CEO compensation data, we find evidence of the role of performance thresholds. As a consequence of under-threshold performance, the tobit estimator is shown to increase pay-performance sensitivity, notably improving upon the standard OLS estimator.

Suggested Citation

  • Xianming Zhou & Peter L. Swan, 2003. "Performance Thresholds in Managerial Incentive Contracts," The Journal of Business, University of Chicago Press, vol. 76(4), pages 665-696, October.
  • Handle: RePEc:ucp:jnlbus:v:76:y:2003:i:4:p:665-696
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    References listed on IDEAS

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    Cited by:

    1. Oriana Bandiera & Iwan Barankay & Imran Rasul, 2007. "Incentives for Managers and Inequality among Workers: Evidence from a Firm-Level Experiment," The Quarterly Journal of Economics, Oxford University Press, vol. 122(2), pages 729-773.
    2. Arup Bose & Debashis Pal & David E. M. Sappington, 2011. "On the Performance of Linear Contracts," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 20(1), pages 159-193, March.
    3. Oxholm, Anne Sophie, 2016. "Physician Response to Target-Based Performance Payment," COHERE Working Paper 2016:9, University of Southern Denmark, COHERE - Centre of Health Economics Research.
    4. Gutiérrez Arnaiz, Óscar & Salas-Fumás, Vicente, 2008. "Performance standards and optimal incentives," Journal of Accounting and Economics, Elsevier, vol. 45(1), pages 139-152, March.
    5. Joseph Y. Chen & Bruce L. Miller, 2009. "On the Relative Performance of Linear vs. Piecewise-Linear-Threshold Intertemporal Incentives," Management Science, INFORMS, vol. 55(10), pages 1743-1752, October.
    6. Hu, Yifan & Zhou, Xianming, 2008. "The performance effect of managerial ownership: Evidence from China," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2099-2110, October.

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