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Department of Business and Management Science, Norwegian School of Economics (NHH) Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)

No 2004/21:
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 career and monetary incentives may be complements, and that stronger ratchet effects or more distortion may increase optimal monetary incentives.

Keywords: Incentive contracts; Performance measures; (follow links to similar papers)

JEL-Codes: J41; (follow links to similar papers)

20 pages, December 29, 2004

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