Incentive Contracts and Performance Measurement

This paper examines the characteristics of incentive contracts in which the agent's payoff is not based on the principal's objective. I show that contracts based on such performance measures will not in general provide first-best incentives, even when the agent is risk neutral. The form of the optimal contract and the efficiency of this contract depend on the relationship between the performance measure used and the principal's objective. The model provides a simple and intuitive statistical measure that serves as a metric for the efficiency of a performance measure. Applications to various incentive contracting situations, including the "gaming" of performance measures, the use of revenue-based sales commissions, and relative performance evaluation, are presented.