Incentive Mechanism Design Aiming at Deflated Performance Manipulation in Retail Firms: Based on the Ratchet Effect and the Reputation Effect

Abstract

Store managers in retail firms are often offered a performance-based compensation scheme accompanied with a performance target by the headquarters. The headquarters adjusts the performance target based on store managers’ historical performance and therefore generates the ratchet effect. Consequently, store managers may downward manipulate performance, that is, deflated performance manipulation, so as to weasel out of target growth and smooth performance growth. However, the reputation effect that seeks fame by store managers can restrain deflated performance manipulation. We model a dynamic agency setting in which both the ratchet effect and the reputation effect are related to the store manager’s compensation scheme, and the store manager has to balance her effort and deflated performance manipulation. Our findings reveal that the ratchet effect and environmental volatility jointly determine the existence of deflated performance manipulation, yet the reputation effect can restrain it with increasing environmental volatility. In addition, deflated performance manipulation is inevitable when environmental volatility is large enough, and explicit incentives may promote deflated performance manipulation.