Optimal Dynamic Relative Performance Evaluation

28 Pages Posted: 23 May 2017

See all articles by Thomas Hemmer

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business

Date Written: May 22, 2017

Abstract

The theoretical prediction of a negative coefficient on positively correlated peer performance underlies much of the empirical literature on relative performance evaluation. This prediction is commonly obtained from the special case of a single period setting where the variance-covariance matrix of the available performance measures is exogenously restricted to be independent of the evaluee’s action. Using the dynamic approach of Holmström and Milgrom (1987), I study the properties of contracts that optimally condition an agent’s compensation both on his own performance and on how well he fares relative to a peer (group) when these restrictions are not imposed. I show that if the covariance is non-zero, the optimal contract is linear in own and peer performance as well as the correlation between own and peer performance. In contrast, and in line with the preponderance of the empirical evidence, in its simplest form the model predicts that the expected coefficient on peer performance is exactly zero.

Suggested Citation

Hemmer, Thomas, Optimal Dynamic Relative Performance Evaluation (May 22, 2017). Available at SSRN: https://ssrn.com/abstract=2972313 or http://dx.doi.org/10.2139/ssrn.2972313

Thomas Hemmer (Contact Author)

Rice University - Jesse H. Jones Graduate School of Business ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States

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