Endogenous criteria for success

Abstract

Economic agents are motivated to undertake costly actions by the prospect of being rewarded for successes and punished for failures. But what determines what a success looks like? This paper endogenizes the criteria for success in an otherwise standard principal-agent model with risk neutrality and limited liability. The set of feasible contracts is constrained by incentive constraints and possibly by a budget constraint. The first-order approach is not required to solve the problem. If the principal manipulates the criteria for success only to lower implementation costs, and depending on which type of constraint is more restrictive, the second-best action may be above or below the first-best action. In a class of problems where the principal's payoff depends directly on the criteria for success, the second-best solution features either more stringent criteria for success or a lower action (or both) than the first-best solution.