Incentive contracts and performance measurement
Abstract
This paper examines the characteristics of incentive contracts in which the agent's payoff is not based on the principal's objective. I show that contracts based on such performance measures will not in general provide first-best incentives, even when the agent is risk neutral. The form of the optimal contract and the efficiency of this contract depend on the relationship between the performance measure used and the principal's objective. The model provides a simple and intuitive statistical measure that serves as a metric for the efficiency of a performance measure. Applications to various incentive contracting situations, including the "gaming" of performance measures, the use of revenue-based sales commissions, and relative performance evaluation, are presented.
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It is well known from practice and theory that explicit performance incentives may be harmful because they induce employees to concentrate only on rewarded tasks and neglect non-rewarded tasks.
“It is well known from practice (Kerr 1975) and from theory (Holmström and Milgrom 1991, Baker 1992) that in this situation explicit performance incentives may be harmful because they induce the employees to concentrate only on the rewarded tasks and to neglect the non-rewarded tasks.”
From Psychological foundations of incentives (2002) · cites this paper as Baker 1992
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Psychological foundations of incentives
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- Authors
- Baker, G. P.
- Corresponding author
- Baker, George P.
- Venue
- Journal of Political Economy
- Publisher
- University of Chicago Press
- Published
- 1992-06
- Volume
- 100
- Issue
- 3
- Pages
- 598-614
- ISSN
- 0022-3808 (ISSN-L)
- 1537-534X
- OpenAlex
- W2055022672
- Cited by
- 1,085
- References
- 18
- Citations by year
- 2026: 34 · 2025: 33 · 2024: 19 · 2023: 28 · 2022: 27 · 2021: 38 · 2020: 33 · 2019: 36 · 2018: 34 · 2017: 42 · 2016: 52 · 2015: 51 · 2014: 43 · 2013: 54 · 2012: 56
- FWCI
- 8.34
- Type
- journal article
- Language
- en
- Open access
- closed
- Locations
- Journal of Political Economy (publishedVersion)
- Topics
- Social Sciences › Decision Sciences › Management Science and Operations Research › Auction Theory and Applications
- Social Sciences › Business, Management and Accounting › Management Information Systems › Accounting and Organizational Management
- Social Sciences › Economics, Econometrics and Finance › Economics and Econometrics › Law, Economics, and Judicial Systems
- Keywords
- incentive contracts, performance measurement, agency theory, risk-neutral agents, optimal contracts, contract efficiency, relative performance evaluation
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