An Empirical Investigation of the Relative Performance Evaluation Hypothesis

Abstract

The principal-agent framework has become a widely used paradigm in accounting and economics for analyzing issues in performance evaluation, management control, and the design of incentive systems. While recent work in experimental economics has begun to examine empirically some of the underlying assumptions and implications of agency theory (see Baiman and Lewis [1989] and Kirby [forthcoming]), few precise hypotheses have been tested using real-world or naturally-occurring data. One exception has been the empirical investigation of the relative performance evaluation (RPE) hypothesis. Agency theory suggests that there are benefits associated with evaluating agents on the basis of their relative performances when the agents' performances are affected by a common term (e.g., see Diamond and Verrecchia [1982] and Holmstrom [1979; 1982]). Specifically, a relative performance-based contract can remove the common shock term from an agent's performance, which enables a better evaluation of the agent's actions.