Relative Performance Evaluation and the Ratchet Effect

Pablo Casas Arce, Martin Holzhacker, Matthias D. Mahlendorf, Michal Matejka

Research output: Contribution to journalArticle

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Abstract

When targets depend on past performance, incentives are adversely affected by the ratchet effect. We provide theory and evidence that incorporating past peer performance into targets can alleviate this adverse incentive effect. In particular, we present an analytical model that characterizes optimal target revisions as a function of past own and past peer performance. We then test the predictions of our model using data on 2008–2010 performance targets from 354 units of a governmental agency responsible for reintegration of the long-term unemployed into the labor market. As a unique feature of our data, we have information on peer group quality, defined as the extent to which peer performance is informative about common shocks. Consistent with our model, we find that higher peer group quality (a) increases sensitivity of target revisions to past peer performance, (b) reduces sensitivity of target revisions to past own performance, and (c) reduces the ratchet effect as reflected in managerial incentives to withhold end-of-year effort.

Original languageEnglish (US)
Pages (from-to)1702-1731
Number of pages30
JournalContemporary Accounting Research
Volume35
Issue number4
DOIs
StatePublished - Dec 1 2018

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ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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