Effective utility functions induced by organizational target-based incentives

Ali E. Abbas, James E. Matheson and Robert F. Bordley
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Ali E. Abbas: Department of Industrial and Enterprise Systems Engineering, College of Engineering, University of Illinois at Urbana-Champaign, Urbana, IL, USA, Postal: Department of Industrial and Enterprise Systems Engineering, College of Engineering, University of Illinois at Urbana-Champaign, Urbana, IL, USA
James E. Matheson: SmartOrg, Inc., Menlo Park, Stanford University, CA, USA, Postal: SmartOrg, Inc., Menlo Park, Stanford University, CA, USA
Robert F. Bordley: GM Technical Fellow, GM Research Labs, Warren, Detroit, MI, USA, Postal: GM Technical Fellow, GM Research Labs, Warren, Detroit, MI, USA

Managerial and Decision Economics, 2009, vol. 30, issue 4, pages 235-251

Abstract: Many companies set performance targets for their divisions to decentralize the decision-making process and communicate with outside investors. This paper analyzes the effects of performance targets on the decision-making behavior of the divisions. We introduce the notion of an 'effective utility function'-a function that a division should use in its selection of projects if it wishes to maximize the probability of achieving its targets. We show that many target-based incentives induce S-shaped utility functions and discuss the organizational problems they may pose. We then show how an organization can set targets that induce expected utility maximization. Copyright © 2008 John Wiley & Sons, Ltd.

Date: 2009
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Persistent link: http://EconPapers.repec.org/RePEc:wly:mgtdec:v:30:y:2009:i:4:p:235-251

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