Determinants of the Importance of Signals on Ability in the Presence of Adverse Selection

Abstract

This paper analyzes the tradeoffs associated with relying on performance versus ability measures in executive compensation. We propose a principal-agent model in which the principal designs the compensation scheme to be contingent on the outcome of interest to the principal along with a noisy signal of the agent’s ability. The outcome depends on managerial effort and ability. The signal of ability may include traditional measures of human capital, as well as information gleaned from private interactions with the agent. We consider two information structures: pure adverse selection (unobservable ability), and the scenario with moral hazard and adverse selection (unobservable effort and ability). In each information structure, we determine the conditions under which the principal places positive or negative weights on the outcome and signal of ability; when the principal relies more heavily on the outcome relative to the signal of ability; and relate our findings to the adjusted sensitivity results in Banker and Datar (1989). Finally, we compare the weights placed on the outcome and signal of ability across the two information structures, to determine the implications of introducing moral hazard.