The Ratchet Effect: Theory and Empirical Evidence

42 Pages Posted: 20 May 2020 Last revised: 22 Jun 2022

See all articles by Michal Matejka

Michal Matejka

Arizona State University

Matthias D. Mahlendorf

Frankfurt School of Finance & Management

Utz Schäffer

WHU Otto Beisheim School of Management

Date Written: June 21, 2022

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

Suggested Citation

Matejka, Michal and Mahlendorf, Matthias D. and Schäffer, Utz, The Ratchet Effect: Theory and Empirical Evidence (June 21, 2022). Available at SSRN: https://ssrn.com/abstract=3583697 or http://dx.doi.org/10.2139/ssrn.3583697

Michal Matejka (Contact Author)

Arizona State University ( email )

Tempe, AZ 85287-3706
United States
480-965-7984 (Phone)

Matthias D. Mahlendorf

Frankfurt School of Finance & Management ( email )

Adickesallee 34
Frankfurt, DE RLP 60322
Germany

Utz Schäffer

WHU Otto Beisheim School of Management ( email )

Burgplatz 2
Vallendar, D-56179
Germany

HOME PAGE: http://www.whu.edu/controlling

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