Performance standards and optimal incentives

This paper analyzes incentive design when agents' effort influences an uncertain output governed by a random process with semi-heavy tails. We find that the second-best incentive contract pays an output-increasing but bounded fee with a shape resembling performance-standard contracts that pay a fixed salary plus a capped bonus. In this contract, the pay-performance sensitivity around the standard increases (decreases) with the frequency with which performance is measured and with the kurtosis (volatility) parameter of the performance probability distribution. We also find that the optimal maximum bonus increases with volatility but decreases with the kurtosis parameter of the performance distribution. (c) 2007 Elsevier B.V. All rights reserved.