Management Accounting Section Midyear Meeting

Learning and the Ratchet Effect

• In Event: Break/Research Exhibition 1: Budgeting and Target Setting

Abstract

Target setting based on past performance can cause the ratchet effect problem. Prior literature has been searched for a way to resolve the ratchet effect and accounting empirical evidence shows that the principal's commitment power is working to prevent it in reality. However, those prior studies mainly assume the agent's ability as constant over periods. Using a two-period adverse selection model, this study investigates how the principal can prevent the ratchet effect when the agent improves ability over time by learning. The results show that if low-ability agents growth more than high-ability agents by the virtue of their larger room for improvement, then the principal can prevent the ratchet effect easily. Since the principal is aware of the ability improvement, the principal determines targets to fit future improved ability level. The key assumption of here is low-ability agents can growth more than high-ability agents. In this case, even if a high-ability agent pretends to be less capable, he will be assigned a target for the improved skill level of a low-ability agent. As a result, the larger a low-ability agent growth, the less the benefit that a skillful worker accrues from pretending to be a less skillful one in the first period. This implies that the principal can prevent the ratchet effect by setting targets considering not only past performance but also growth expectations. More importantly, this study suggests that the prior empirical evidence on the principal's commitment power may not indicate the existence of that commitment power but rather caused by the principal's ignorance of the agents' ability growth. It points out the need for further investigation before concluding that the real-world principal has sufficient commitment power.

Author

• Mami Koyama, Kobe University