Optimal Performance Targets

• In Event: Incentives and Performance Evaluation

Abstract

I study a class of contracts that is becoming ever more common among executives, in which the manager earns a discrete bonus if his performance clears an explicit threshold. These performance targets provide the firm with an additional instrument to resolve its moral hazard and adverse selection problems with its manager. The performance target easily achieves first best under risk neutrality, setting the target precisely equal to the desired effort that the firm seek to induce. If the manager is risk averse, the firm will shade the optimal target below equilibrium effort to provide a form of insurance to the manager, outside of the standard reduction in the bonus. In particular, this can reverse the risk-incentives trade-off, where now the optimal bonus increases in risk.

Author

• Korok Ray, Texas A&M University