Abstract
AbstractIn this paper we analyze a dynamic agency problem where contracting parties do not know the agent’s future productivity at the beginning of the relationship. We consider a two-period model where both the agent and the principal observe the agent’s second-period productivity at the end of the first period. This observation is assumed to be non-verifiable information. We compare long-term contracts with short-term contracts with respect to their suitability to motivate effort in both periods. On the one hand, short-term contracts allow for a better fine-tuning of second-period incentives as they can be aligned with the agent’s second-period productivity. On the other hand, in short-term contracts first-period effort incentives might be distorted as contracts have to be sequentially optimal. Hence, the difference between long-term and short-term contracts is characterized by a trade-off between inducing effort in the first and in the second period. We analyze the determinants of this trade-off and demonstrate its implications for performance measurement and information system design.
Highlights
The agency-theoretic literature has spent an enormous amount of effort analyzing long-term incentive problems (e.g., Lambert 1983, Fudenberg, Holmstrom, and Milgram 1990, Chiappori, Macho, Rey, and Salanie 1994, or Christensen, Feltham, and ~abac 2005)
Firm value is not contractible such that effort incentives must be motivated via a performance measurement system
We derived that the sequentially optimal second-period incentive rate can be implemented in long-term contracts only if the posterior mean of second-period firm value productivity is a linear function of the observed productivity
Summary
The agency-theoretic literature has spent an enormous amount of effort analyzing long-term incentive problems (e.g., Lambert 1983, Fudenberg, Holmstrom, and Milgram 1990, Chiappori, Macho, Rey, and Salanie 1994, or Christensen, Feltham, and ~abac 2005). A general lesson from analyzing long-term incentive problems is that slight changes in the information structure may have substantial consequences for the outcome of the agency and may lead to different recommendations for optimal performance management and information system design. We consider a two-period agency relationship in which the contracting parties privately observe the agent's second-periodproductivityat the end ofthe first period The idea underlying this assumption is that the manager's future contribution to both firm value and performance measures is uncertain ex ante but becomes more transparent by observing the production process over time. Within this setting we analyze the trade-off between early and late effort motivation by comparing short-term contracts with long-term contracts.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Free) 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
