Optimal Performance Targets

Abstract

I study a class of contracts that is becoming ever more common among executives, in which the manager earns a discrete bonus if his performance clears an explicit threshold. These performance targets provide the firm with an additional instrument to resolve its moral hazard and adverse selection problems with its manager. The performance target can achieve first best under risk neutrality, with a target precisely equal to the desired effort that the firm seeks to induce. The optimal bonus increases in risk. If the manager is risk averse, the firm will shade the optimal target below equilibrium effort to provide a form of insurance to the manager, outside of the standard reduction in the bonus. When the manager has private information on his ability, the optimal bonus and target both increase in ability, to discourage misreporting of his private information. I’d like to acknowledge the helpful comments of Prasart Jongjaroenkamol, Volker Laux, Pierre Liang, Adrienne Rhodes, Florin Sabac, Jack Stecher, and seminar participants at the University of Alberta, Carnegie Mellon University, the University of Texas at Austin, and Texas A&M University. Anna Dai and Mehmet Kara provided excellent research assistance.