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Department of Economics, University of Bergen Working Papers in Economics, Department of Economics, University of Bergen

No 07/06:
Distorted Performance Measures and Dynamic Incentives

Oddvar M. Kaarbøe () and Trond E. Olsen ()

Abstract: Incentive contracts must typically be based on performance measures that do not exactly match agents’ true contribution to principals’ objectives. Such misalignment may impose difficulties for effective incentive design. We analyze to what extent implicit dynamic incentives such as career concerns and ratchet effects alleviate or aggravate these problems. Our analysis demonstrates that the interplay between distorted performance measures and implicit incentives implies that career and ratchet effects have real effects, that stronger ratchet effects or more distortion may increase optimal monetary incentives, and that bureaucratic promotion rules may be optimal.

Keywords: Search; Learning; Information and Knowledge; Communication; Belief; Compensation Packages; Payment Methods; Labor Management.; (follow links to similar papers)

JEL-Codes: D83; J33; M54; (follow links to similar papers)

29 pages, June 9, 2006

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