Subjective Performance Measures in Optimal Incentive Contracts

39 Pages Posted: 14 Jan 2001 Last revised: 8 Mar 2010

See all articles by George P. Baker

George P. Baker

HBS Negotiations, Organizations and Markets Unit; National Bureau of Economic Research (NBER)

Robert S. Gibbons

Massachusetts Institute of Technology - Sloan School and Department of Economics; National Bureau of Economic Research (NBER)

Kevin J. Murphy

University of Southern California - Marshall School of Business; USC Gould School of Law

Date Written: September 1993

Abstract

Objective measures of performance are seldom perfect. In response, incentive contracts often include important subjective components that mitigate incentive distortions caused by imperfect objective measures. This paper explores the combined use of subjective and objective performance measures in (respectively) implicit and explicit incentive contracts. Naturally, objective and subjective measures often are substitutes, sometimes strikingly so: we show that if objective measures are sufficiently close to perfect then no implicit contracts are feasible (because the firm's fallback position after reneging on an implicit contact is too attractive). We also show, however, that objective and subjective measures can reinforce each other: if objective measures become more accurate then in some circumstances the optimal contract puts more weight on subjective measures (because the improved objective measures increase the value of the ongoing relationship, and so reduce the firm's incentive to renege). We also analyze the use of subjective weights on objective performance measures, and provide case-study evidence consistent with our analyses.

Suggested Citation

Baker, George P. and Gibbons, Robert S. and Murphy, Kevin J., Subjective Performance Measures in Optimal Incentive Contracts (September 1993). NBER Working Paper No. w4480. Available at SSRN: https://ssrn.com/abstract=245843

George P. Baker (Contact Author)

HBS Negotiations, Organizations and Markets Unit ( email )

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HOME PAGE: http://www.people.hbs.edu/gbaker/index.html

National Bureau of Economic Research (NBER)

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Robert S. Gibbons

Massachusetts Institute of Technology - Sloan School and Department of Economics ( email )

E52-432
MIT
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617-258-6855 (Fax)

National Bureau of Economic Research (NBER)

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United States

Kevin J. Murphy

University of Southern California - Marshall School of Business ( email )

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Los Angeles, CA 90089-0804
United States
213-740-6553 (Phone)
213-740-6650 (Fax)

USC Gould School of Law

699 Exposition Boulevard
Los Angeles, CA 90089
United States

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