Scandinavian Working Papers in Business Administration

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

No 2004/21: 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: Programme for Health Economics (HEB), Department of Economics, University of Bergen, Fosswinckelsg. 6, N-5007 Bergen, Norway
Trond E. Olsen: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, 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 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

JEL-codes: J41

20 pages, December 29, 2004

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