Optimal Incentives and the Time Dimension of Performance Measurement

Abstract:     
In many occupations, the consequences of agents' actions become known only over time. Firms can then pay agents based on early but noisy performance measures, or later but more accurate ones. I study this choice within a two-period model in which an agent's action generates an output with delay, and a noisy signal of output early. While the signal is useful for early consumption decisions, it is not clear that the signal is useful for incentive contracting if the agent has access to credit. I show, however, that under very general conditions the optimal contract depends on the early signal as well as on output even if the signal is uninformative of effort, given output, and even if the agent has perfect access to credit. An important characteristic of any performance measure, therefore, is the time at which it is generated. The results shed light on the use of forward-looking performance measures such as stock returns in managerial incentive contracts.

Keywords: optimal incentives, performance measurement, intertemporal consumption, informativeness, timeliness

JEL Classifications: D86, D91, J33, M52

Working Paper Series