Optimal Performance Targets

What is it about?

We study a class of contracts that is becoming ever more common among executives, in which the manager earns a discrete bonus if performance clears an explicit threshold. These performance targets provide the firm with an additional instrument to resolve its moral hazard problem with its manager. The performance target can achieve first-best under risk neutrality, with a target precisely equal to the desired effort that the firm seeks to induce. The optimal bonus increases in risk. If the manager is sufficiently risk averse, the firm will shade the optimal target below equilibrium effort to provide a form of insurance to the manager, outside of the standard reduction in the bonus.

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