Distorted Performance Measures and Dynamic Incentives

Abstract

Incentive contracts must typically be based on performance measures that do not exactly match the agents' true contribution to the principals' objectives. Such misalignment may pose difficulties for effective incentive design. We analyze the extent to which implicit dynamic incentives, such as career concerns and ratchet effects, alleviate or aggfravate these problems. Our analysis demonstrates that the interplay between distorted performance measures and implicit incentives implies that career and ratchet effects have real effects in that stronger ratchet effects or greater distortion may increase optimal monetary incentives, and that distortion affects the optimality of different promotion rules.