IDEAS home Printed from https://ideas.repec.org/a/eee/jeborg/v166y2019icp309-331.html
   My bibliography  Save this article

Objective and subjective indicators in long-term contracting

Author

Listed:
  • Au, Pak Hung
  • Chen, Bin R.

Abstract

We study the optimal compensation contract in a dynamic moral hazard setting with limited liability and two stages of production. At the end of the first stage, both an objective signal (publicly observed) and a subjective signal (privately observed by the principal) realize, and they are informative of the second-stage productivity. We show that in the optimal long-term contract, the two signals are used interactively with three notable features. First, whereas the objective signal is always used in the optimal contract, the subjective signal is used only if the realized value of objective signal is below a cutoff. Second, the solicited effort may exhibit an upward distortion (relative to the first best) for an intermediate region of the objective signal realizations. Third, the use of subjectivity varies with a number of factors such as the signal quality and the severity of the moral hazard problem.

Suggested Citation

  • Au, Pak Hung & Chen, Bin R., 2019. "Objective and subjective indicators in long-term contracting," Journal of Economic Behavior & Organization, Elsevier, vol. 166(C), pages 309-331.
    • Handle: RePEc:eee:jeborg:v:166:y:2019:i:c:p:309-331
    DOI: 10.1016/j.jebo.2019.06.020
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0167268119302100
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jebo.2019.06.020?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Gustavo Manso, 2011. "Motivating Innovation," Journal of Finance, American Finance Association, vol. 66(5), pages 1823-1860, October.
    2. Korok Ray, 2007. "Performance Evaluations and Efficient Sorting," Journal of Accounting Research, Wiley Blackwell, vol. 45(4), pages 839-882, September.
    3. Jonathan Levin, 2003. "Relational Incentive Contracts," American Economic Review, American Economic Association, vol. 93(3), pages 835-857, June.
    4. Ronald A. Dye & Sri S. Sridhar, 2005. "Moral Hazard Severity and Contract Design," RAND Journal of Economics, The RAND Corporation, vol. 36(1), pages 78-92, Spring.
    5. Bentley W. MacLeod, 2003. "Optimal Contracting with Subjective Evaluation," American Economic Review, American Economic Association, vol. 93(1), pages 216-240, March.
    6. Beaudry, Paul, 1994. "Why an Informed Principal May Leave Rents to an Agent," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 35(4), pages 821-832, November.
    7. Marie-Cécile Fagart & Bernard Sinclair-Desgagné, 2007. "Ranking Contingent Monitoring Systems," Management Science, INFORMS, vol. 53(9), pages 1501-1509, September.
    8. Chade, Hector & Silvers, Randy, 2002. "Informed principal, moral hazard, and the value of a more informative technology," Economics Letters, Elsevier, vol. 74(3), pages 291-300, February.
    9. Rachel M. Hayes & Scott Schaefer, 2000. "Implicit Contracts and the Explanatory Power of Top Executive Compensation for Future Performance," RAND Journal of Economics, The RAND Corporation, vol. 31(2), pages 273-293, Summer.
    10. Inderst, Roman, 2001. "Incentive schemes as a signaling device," Journal of Economic Behavior & Organization, Elsevier, vol. 44(4), pages 455-465, April.
    11. George Baker & Robert Gibbons & Kevin J. Murphy, 1994. "Subjective Performance Measures in Optimal Incentive Contracts," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 1125-1156.
    12. Bushman, Robert M. & Indjejikian, Raffi J. & Smith, Abbie, 1996. "CEO compensation: The role of individual performance evaluation," Journal of Accounting and Economics, Elsevier, vol. 21(2), pages 161-193, April.
    13. Lambert, Ra, 1985. "Variance Investigation In Agency Settings," Journal of Accounting Research, Wiley Blackwell, vol. 23(2), pages 633-647.
    14. Fong, Yuk-fai & Li, Jin, 2017. "Relational contracts, limited liability, and employment dynamics," Journal of Economic Theory, Elsevier, vol. 169(C), pages 270-293.
    15. Young, Ra, 1986. "A Note On Economically Optimal Performance Evaluation And Control-Systems - The Optimality Of 2-Tailed Investigations," Journal of Accounting Research, Wiley Blackwell, vol. 24(1), pages 231-240.
    16. Elchanan Ben-Porath & Eddie Dekel & Barton L Lipman, 2018. "Disclosure and Choice," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(3), pages 1471-1501.
    17. Patrick W. Schmitz, 2005. "Allocating Control in Agency Problems with Limited Liability and Sequential Hidden Actions," RAND Journal of Economics, The RAND Corporation, vol. 36(2), pages 318-336, Summer.
    18. Bin R. Chen & Y. Stephen Chiu, 2013. "Interim Performance Evaluation in Contract Design," Economic Journal, Royal Economic Society, vol. 123, pages 665-698, June.
    19. William Fuchs, 2007. "Contracting with Repeated Moral Hazard and Private Evaluations," American Economic Review, American Economic Association, vol. 97(4), pages 1432-1448, September.
    20. Baiman, S & Demski, Js, 1980. "Economically Optimal Performance Evaluation And Control-Systems," Journal of Accounting Research, Wiley Blackwell, vol. 18, pages 184-220.
    21. Susanne Ohlendorf & Patrick W. Schmitz, 2012. "Repeated Moral Hazard And Contracts With Memory: The Case Of Risk‐Neutrality," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 53(2), pages 433-452, May.
    22. Nieken, Petra & Schmitz, Patrick W., 2012. "Repeated moral hazard and contracts with memory: A laboratory experiment," Games and Economic Behavior, Elsevier, vol. 75(2), pages 1000-1008.
    23. Narisa Tianjing Dai & Xi (Jason) Kuang & Guliang Tang, 2018. "Differential Weighting of Objective Versus Subjective Measures in Performance Evaluation: Experimental Evidence," European Accounting Review, Taylor & Francis Journals, vol. 27(1), pages 129-148, January.
    24. William Fuchs, 2015. "Subjective Evaluations: Discretionary Bonuses and Feedback Credibility," American Economic Journal: Microeconomics, American Economic Association, vol. 7(1), pages 99-108, February.
    25. Suvorov, Anton & van de Ven, Jeroen, 2009. "Discretionary rewards as a feedback mechanism," Games and Economic Behavior, Elsevier, vol. 67(2), pages 665-681, November.
    26. Ederhof, Merle & Rajan, Madhav V. & Reichelstein, Stefan, 2011. "Discretion in Managerial Bonus Pools," Foundations and Trends(R) in Accounting, now publishers, vol. 5(4), pages 243-316, June.
    27. Madhav V. Rajan & Stefan Reichelstein, 2006. "Subjective Performance Indicators and Discretionary Bonus Pools," Journal of Accounting Research, Wiley Blackwell, vol. 44(3), pages 585-618, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Müller, Daniel & Schmitz, Patrick W., 2021. "The right to quit work: An efficiency rationale for restricting the freedom of contract," Journal of Economic Behavior & Organization, Elsevier, vol. 184(C), pages 653-669.
    2. Schmitz, Patrick W., 2023. "Incentivizing research with (un)conditional teaching duties: Punishment or rent extraction?," Economics Letters, Elsevier, vol. 224(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Bin R. Chen & Sanxi Li, 2018. "Prehire Screening and Subjective Performance Evaluations," Management Science, INFORMS, vol. 64(10), pages 4953-4965, October.
    2. Matthias Lang, 2023. "Stochastic contracts and subjective evaluations," RAND Journal of Economics, RAND Corporation, vol. 54(1), pages 104-134, March.
    3. Chen, Bin R., 2015. "Subjective performance feedback, ability attribution, and renegotiation-proof contracts," Journal of Economic Behavior & Organization, Elsevier, vol. 117(C), pages 155-174.
    4. Ján Zábojník, 2014. "Subjective evaluations with performance feedback," RAND Journal of Economics, RAND Corporation, vol. 45(2), pages 341-369, June.
    5. Terstiege, Stefan, 2013. "Objective versus Subjective Performance Evaluations," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 430, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
    6. Lang, Matthias, 2019. "Communicating subjective evaluations," Journal of Economic Theory, Elsevier, vol. 179(C), pages 163-199.
    7. Shingo Takahashi & Hideo Owan & Tsuyoshi Tsuru & Katsuhito Uehara, 2014. "Perceptions to climatic changes and cooperative attitudes toward flood protection in Bangladesh," Working Papers EMS_2014_11, Research Institute, International University of Japan.
    8. Bin R. Chen & Y. Stephen Chiu, 2013. "Interim Performance Evaluation in Contract Design," Economic Journal, Royal Economic Society, vol. 123, pages 665-698, June.
    9. Jan Zabojnik, 2011. "Subjective Evaluations With Performance Feedback," Working Paper 1283, Economics Department, Queen's University.
    10. Terstiege, Stefan, 2014. "Private versus verifiable interim performance evaluations under uncertainty," Economics Letters, Elsevier, vol. 123(3), pages 341-344.
    11. Helmut Bester & Johannes Münster, 2016. "Subjective evaluation versus public information," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 61(4), pages 723-753, April.
    12. Helmut Bester & Matthias Dahm, 2018. "Credence Goods, Costly Diagnosis and Subjective Evaluation," Economic Journal, Royal Economic Society, vol. 128(611), pages 1367-1394, June.
    13. Madhav V. Rajan & Stefan Reichelstein, 2006. "Subjective Performance Indicators and Discretionary Bonus Pools," Journal of Accounting Research, Wiley Blackwell, vol. 44(3), pages 585-618, June.
    14. Daniel Müller & Philipp Weinschenk, 2015. "Rater Bias and Incentive Provision," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 24(4), pages 833-862, October.
    15. Mengxi Zhang, 2019. "When the principal knows better than the agent: Subjective evaluations as an optimal disclosure mechanism," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 28(4), pages 631-655, November.
    16. Kräkel, Matthias, 2017. "Self-organizing teams," Economics Letters, Elsevier, vol. 159(C), pages 195-197.
    17. Xinhao He & Jin Li & Zhaoneng Yuan, 2022. "Optimal Subjective Contracting with Revision," Management Science, INFORMS, vol. 68(8), pages 6346-6354, August.
    18. Ishiguro, Shingo & Yasuda, Yosuke, 2023. "Moral hazard and subjective evaluation," Journal of Economic Theory, Elsevier, vol. 209(C).
    19. Jörg Budde, 2007. "Performance Measure Congruity and the Balanced Scorecard," Journal of Accounting Research, Wiley Blackwell, vol. 45(3), pages 515-539, June.
    20. Dmitry Orlov, 2014. "Optimal Design of Internal Disclosure," 2014 Meeting Papers 314, Society for Economic Dynamics.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jeborg:v:166:y:2019:i:c:p:309-331. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jebo .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.