Subjective Performance Measures in Optimal Incentive Contracts

Abstract

Incentive contracts often include important subjective components that mitigate incentive distortions caused by imperfect objective measures. This paper explores the combined use of subjective and objective performance measures in (respectively) implicit and explicit incentive contracts. We show that the presence of sufficiently effective explicit contracts can render all implicit contracts infeasible, even those that would otherwise yield the first-best. We also show, however, that in some circumstances objective and subjective measures are complements: neither an explicit nor an implicit contract alone yields positive profit, but an appropriate combination of the two does. Finally, we consider subjective weights on objective measures.