Subjective Performance Measures in Optimal Incentive Contracts

Abstract

Objective measures of performance are seldom perfect. In response, incentive contracts often include important subjective components that mitigate incentive distortions caused by imperfect objective measures. This paper explores the combined use of subjective and objective performance measures in (respectively) implicit and explicit incentive contracts. Naturally, objective and subjective measures often are substitutes, sometimes strikingly so: we show that if objective measures are sufficiently close to perfect then no implicit contracts are feasible (because the firm’s fallback position after reneging on an implicit contract is too attractive). We also show, however, that objective and subjective measures can reinforce each other: if objective measures become more accurate then in some circumstances the optimal contract puts more weight on subjective measures (because the improved objective measures increase the value of the ongoing relationship, and so reduce the firm’s incentive to renege). We also analyze the use of subjective weights on objective performance measures, and provide case-study evidence consistent with our analyses.