Leading Indicator Variables, Performance Measurement and Long-Term Versus Short-Term Contracts

46 Pages Posted: 30 Jun 2003

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2003

Abstract

This paper develops a multiperiod agency model to study the use of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake "soft" investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables which provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract.

With short-term contracts, leading indicator variables are essential in mitigating a "holdup" problem resulting from the fact that investments are sunk at the end of the first period. With long-term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long-term contract induces larger investments and less reliance on the leading indicator variables in comparison to short-term contracts. Under certain conditions, though, the principal does better with a sequence of one-period contracts than with a long-term contract.

JEL Classification: M40, M46, J33

Suggested Citation

Dutta, Sunil and Reichelstein, Stefan J., Leading Indicator Variables, Performance Measurement and Long-Term Versus Short-Term Contracts (May 2003). Available at SSRN: https://ssrn.com/abstract=414143 or http://dx.doi.org/10.2139/ssrn.414143

Sunil Dutta (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

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Stanford, CA 94305-5015
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650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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HOME PAGE: http://www.CESifo.de

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