How Does Ratchet Effect Rise and Sag? Empirical Evidence with Respect to Target Ambiguity, Interactive Target Setting, and Measurement Noise

Abstract

This study builds on the ratchet principle literature and examines the subordinate’s incentive to reduce the effort level in target setting procedure. Using the data containing both actual and target performances, we provide direct empirical evidences as to the predictions by the ratchet principle theory. We find that, when the target performance in the future period is substantially influenced by the current performance (ratchet principle), subordinates lose incentives to exert to maximize the current performance (ratchet effect). We next investigate the impact of target ambiguity on the magnitude of the ratchet effect. We find stronger ratchet effect when it is difficult for the superior to figure out the true level of target performance. That is, in such circumstances where the superior possesses limited prior knowledge about the indubitable target performance, subordinates are reluctant to exert for the best level of current performance because the target for the following period must depend largely on the realized performance. Furthermore, our empirical analyses suggest two remedies for the subordinate’s effort reduction incentive given the ambiguous target: increased participation of subordinates in the target setting process and increased noise in the performance measure.