Optimal Dynamic Relative Performance Evaluation

ABSTRACT The theoretical prediction of a negative coefficient on positively correlated peer performance underlies much of the empirical literature on relative performance evaluation. This prediction is commonly obtained from a single period model where the variance–covariance matrix of available performance measures is exogenously restricted to be independent of the evaluee’s action. Using the dynamic approach of Holmström and Milgrom (1987), I study the properties of contracts that optimally condition an agent’s compensation both on his own performance and on how well he fares relative to a peer (group) when these restrictions are not imposed. I show that if the covariance is nonzero, the optimal contract is linear in own and peer performance as well as in their correlation. Significantly, and in line with the preponderance of the empirical evidence, in its simplest and perhaps most reasonable form, the model predicts that the expected coefficient on peer performance is exactly zero.