The Use of Performance Measures in Incentive Contracting

The characteristics of performance measures (those data on which explicit incentive contracts are based) are examined to understand how firms use incentive contracting, and to predict the use of incentives in practice. Two ways of thinking about the choice of performance measures are suggested. The first, and the perspective used in the paper, is to suppose the existence of a set of performance measures that the firm could use in an incentive contract and ask which measure yields the strongest incentives or the highest surplus. The second way of looking at the question is to ask how much the firm should pay to develop better performance measure.