Decentralization, Incentive Contracts and the Effect of Distortions in Performance Measures

Abstract

A model endogenizing authority over decisions and incentive contracts is developed. In addition to motivating the agent to exert effort, the principal is concerned about some non‐contractible decision that is chosen simultaneously with the agent's effort. The choice of this decision affects both the performance measure and the principal's objective. We consider two allocations of authority to make this decision; principal and agent authority. The choice of authority structure affects the incentive contract, which together with authority structure, affects the agent's effort. We determine the optimal authority structure and incentive contract and how they are affected by different factors.