SUBJECTIVEPERFORMANCEMEASURESINOPTIMALINCENTIVECONTRACTS.pptVIP

SUBJECTIVE PERFORMANCE MEASURES IN OPTIMAL INCENTIVE CONTRACTS Contract Theory and Operation Management Luca Tiozzo “Pezzoli” University Ca’ Foscari (Venice) The Problem How can we measure the performance of employees actions? It should reflect the employee’s contribution to firm value! Hence, it should include static externalities across business and dynamic effects on long-run firm value Objective (Measurable) vs. Subjective (Not Measurable) measures of Performance Only Objective measures of performance induce distorted incentives! We can distinguish two types of contracts: Benchmark Models: the Economic Environment Benchmark Models: The Dynamics Benchmark Models: Explicit Contract Benchmark Models: Implicit Contract Optimal Interplay between Implicit and Explicit Contracts Case Case Subjective Weight on Objective Perf. Measures The firm can assess the incentive distortion caused by the imperfect objective performance measure We assume that the firm and worker observe at the same time, namely for the firm after p is realized. Conclusions Firm has to evaluate the performance of a worker. It can assess in two ways: subjectively of objectively. Objectively: the firm observe the measure of performance and on this basis it evaluates the worker’s performance (Explicit Contract) Subjectively: the firm does not observe the measure of performance but only the realization on its value. It can, in that case, renege the contract. A possible combination of both contract can improve the ongoing relationship By the use of Subjective weight on Objective performance measure, the firm can assess incentive distortion caused by imperfect objective measures of performance * * IMPLICIT CONTRACT EXPLICIT CONTRACT Subjective Measure of Performance Objective Measure of Performance Substitute Nature of Contracts: Objective measure close to be perfect, no place for Implicit contract Complement Nature of Contracts: