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Effective utility functions induced by organizational target-based incentives

Author

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  • Ali E. Abbas

    (Department of Industrial and Enterprise Systems Engineering, College of Engineering, University of Illinois at Urbana-Champaign, Urbana, IL, USA)

  • James E. Matheson

    (SmartOrg, Inc., Menlo Park, Stanford University, CA, USA)

  • Robert F. Bordley

    (GM Technical Fellow, GM Research Labs, Warren, Detroit, MI, USA)

Abstract

Many companies set performance targets for their divisions to decentralize the decision-making process and communicate with outside investors. This paper analyzes the effects of performance targets on the decision-making behavior of the divisions. We introduce the notion of an 'effective utility function'-a function that a division should use in its selection of projects if it wishes to maximize the probability of achieving its targets. We show that many target-based incentives induce S-shaped utility functions and discuss the organizational problems they may pose. We then show how an organization can set targets that induce expected utility maximization. Copyright © 2008 John Wiley & Sons, Ltd.

Suggested Citation

  • Ali E. Abbas & James E. Matheson & Robert F. Bordley, 2009. "Effective utility functions induced by organizational target-based incentives," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 30(4), pages 235-251.
    • Handle: RePEc:wly:mgtdec:v:30:y:2009:i:4:p:235-251
    DOI: 10.1002/mde.1448
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    References listed on IDEAS

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    Cited by:

    1. Andrea C. Hupman, 2022. "Cutoff Threshold Decisions for Classification Algorithms with Risk Aversion," Decision Analysis, INFORMS, vol. 19(1), pages 63-78, March.
    2. Ali E. Abbas & Il-Horn Hann, 2010. "Measuring Risk Aversion in a Name-Your-Own-Price Channel," Decision Analysis, INFORMS, vol. 7(1), pages 123-136, March.
    3. Shi, Chunming Victor & Zhao, Xuan & Xia, Yu, 2010. "The setting of profit targets for target oriented divisions," European Journal of Operational Research, Elsevier, vol. 206(1), pages 86-92, October.
    4. Van Vliet, Ben, 2017. "Capability satisficing in high frequency trading," Research in International Business and Finance, Elsevier, vol. 42(C), pages 509-521.
    5. Jeffrey M. Keisler & Robert F. Bordley, 2015. "Project Management Decisions with Uncertain Targets," Decision Analysis, INFORMS, vol. 12(1), pages 15-28, March.
    6. Zhengwei Sun & Ali E. Abbas, 2014. "On the sensitivity of the value of information to risk aversion in two-action decision problems," Environment Systems and Decisions, Springer, vol. 34(1), pages 24-37, March.
    7. Maximilian Zellner & Ali E. Abbas, 2023. "Experimental Assessment of Utility Functions Induced by Fixed and Uncertain Targets," Decision Analysis, INFORMS, vol. 20(3), pages 187-201, September.

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