Distorted Performance Measurement and Relational Contracts

Abstract

I analyze the use of alternative performance measures using an agency model that incorporates both formal and informal agreements. I show that under the proper combination of verifiable and unverifiable performance measures, the two types of contract complement each other regardless of the principal’s fallback position. To obtain this complementarity, the principal uses an opting-out clause that allows him to replace part of a piece rate by a predefined bonus. My analysis contrasts with earlier studies, and provides a rationale for the use of subjective information in strategic performance measurement systems.