The Ratchet Effect: Theory and Empirical Evidence

Abstract

Using current performance to set future targets can discourage effort and reduce performance. Our study examines whether this ratchet effect also undermines incentives of high-level managers and executives. We use a dynamic model to show that empirical tests used in prior literature can falsely reject the null hypothesis of no ratchet effect. We also motivate a new test that can better detect the adverse incentives effects of target setting. Specifically, we show that the ratchet effect can be identified as the effect of past performance on changes in perceived target difficulty. We use panel data from nine annual 2011–2019 surveys to implement this test. Similar to prior studies, we find strong evidence that targets are revised upward following good performance. Nevertheless, we reject the ratchet effect hypothesis because we further find that good performance in one period is associated with a decrease in perceived target difficulty in the next period. This finding is more pronounced in settings where well-performing managers have more private information about future performance and where long-term commitments are more credible.

Keywords: Ratchet Effect, Dynamic Incentives, Target Updating

JEL Classification: M41, M52