Speak softly, but carry a big stick: On optimal targets under moral hazard

Abstract

When managerial compensation is restricted to be constant below a certain target output level, and underlying effort is unobserved, a recent article by Liu suggests that the optimal sharing rule should be smooth and locally convex at the target. This is incorrect. If minimum payments are set exogenously, the optimal sharing rule for a risk-averse manager will be kinked at the target. If penalties are unbounded, the principal can approach the first-best full-information outcome by offering a constant payment under normal conditions but imposing a severe punishment for extremely unlikely low outcomes, i.e., by “speaking softly but carrying a big stick.”