Scandinavian Working Papers in Economics

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

No 07/06: Distorted Performance Measures and Dynamic Incentives

Oddvar M. Kaarbøe () and Trond E. Olsen ()
Additional contact information
Oddvar M. Kaarbøe: Programme for Health Economics (HEB), Department of Economics, University of Bergen, Postal: Hermann Fossgt. 6, N-5007 Bergen
Trond E. Olsen: Department of Finance and Management Science, Norwegian School of Economics and Business, Postal: Helleveien 30, N-5045 Bergen, Norway

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.

JEL-codes: D83; J33; M54

29 pages, June 9, 2006

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