Objective and Subjective Indicators in Long-term Contracting

63 Pages Posted: 26 Nov 2018

See all articles by Pak Hung Au

Pak Hung Au

Nanyang Technological University

Bin R. Chen

Sun Yat-sen University (SYSU) - School of Business

Date Written: March 14, 2018

Abstract

We study the optimal compensation contract in a dynamic moral hazard setting with limited liability and two stages of production. At the end of the first stage, both an objective signal (publicly observed) and a subjective signal (privately observed by the principal) realize, and they are informative of the second-stage productivity. We show that in the optimal long-term contract, the two signals are used interactively with three notable features. First, whereas the objective signal is always used in the optimal contract, the subjective signal is used only if the realized value of objective signal is below a cutoff. Second, the solicited effort may exhibit an upward distortion (relative to the first best) for an intermediate region of the objective signal realizations. Third, the use of subjectivity varies with a number of factors such as the signal quality and severity of the moral hazard problem.

Keywords: subjective performance measures, compensation contracts, conditional variance investigation, moral hazard

JEL Classification: D86, M52

Suggested Citation

Au, Pak Hung and Chen, Bin R., Objective and Subjective Indicators in Long-term Contracting (March 14, 2018). Available at SSRN: https://ssrn.com/abstract=3275830 or http://dx.doi.org/10.2139/ssrn.3275830

Pak Hung Au (Contact Author)

Nanyang Technological University ( email )

14, Nanyang Drive, HSS, 04-67
Singapore, 637332
Singapore

Bin R. Chen

Sun Yat-sen University (SYSU) - School of Business ( email )

School of Business
Sun Yat-Sen University
Guangzhou, Guangdong 510275
China
8620 84112761 (Phone)

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