Short-Term Contracts, Long-Term Actions, and Information System Design

Abstract

We examine how “long-term actions” (current period actions that bear fruit in the future) can be motivated when short-term contracts are employed, and derive implications for the design of performance measurement systems. In our two-period model with unknown agent type and moral hazard, the principal chooses between a fine and a coarse performance measurement system. These two systems differ in the information they convey about the agent's unknown type and therefore lead to different retention/firing policies. The principal's retention policy in turn influences the agent's incentives to undertake long-term actions, especially if the agent has advance information about what the performance is likely to be; an employee expecting to get fired is less likely to take actions that will bear fruit only after his departure from the firm. We show that the principal may prefer a coarser performance measurement system because it can substitute for her ability to commit to retention decisions. We also show that the finer the agent's private information is, the greater the benefit for the principal from coarsening the performance measurement system for contracting purposes. We discuss some practical implications of our analysis.