Volume 37, Number 4 (Fall) 2002
Baker, George. 2002. "Distortion and Risk in Optimal Incentive Contracts." Journal of Human Resources 37(4):728-751.
Performance measurement is an essential part of the design of any incentive system. The strength and value of incentives in organizations are strongly affected by the performance measures available. Yet, the characteristics of valuable performance measures have not been well explored in the agency literature. In this paper, I use a multitask model to develop a two-parameter characterization of performance measures and show how these two parameters-distortion and risk-affect the value and use of performance measures in incentive contracts. I show that many complex issues in the design of real-world incentive contracts can be fruitfully viewed as tradeoffs between these two features of performance measures. I also use this framework to analyze the provision of incentives in several specific environments, including R&D labs and nonprofit organizations.
George Baker is a professor of business administration at Harvard University. He would like to thank Nancy Beaulieu, Bob Gibbons, Brian Hall, Ed Lazear, Sherwin Rosen, Jasjit Singh, Lars Stole, an anonymous referee, and participants at the NAS Conference on" Designing Incentives for the Production of Human Capital" for comments on this paper. The research for this paper was funded by the Harvard Business School Division of Research.
© 2003 by the Board of Regents of the University of Wisconsin System
US ISSN 0022-166X