Shaping Incentives through Measurement and Contracts

Abstract

I study productive activity, measurement, and compensation in a principal-agent model that relaxes common restrictions on the action set of the agent, the distribution of performance measures, and the shape of the wage schedule. The solution to this relaxed problem unifies insights from extant theory and shares features with well-known empirical phenomena. In particular, the optimal outcome distribution has a kink, optimal measurement is conservative, and optimal wages ensure congruent incentives and resemble accounting-based bonus plans featuring a floor, hurdle bonus, incentive zone, and ceiling, with thresholds that may reference other performance measures. Beyond these specific insights, the paper provides a flexible framework for studying how incentives are shaped through measurement and contracts.

Keywords: Moral Hazard, Agency Theory, Contracts, Compensation, Accounting, Measurement, Conservatism, Congruity, Bonus Plans

JEL Classification: D86, J41, M41, M52