Ambiguity sharing and the lack of relative performance evaluation

Yaoyao Wu (), Jinqiang Yang () and Zhentao Zou ()
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Yaoyao Wu: Shanghai University of Finance and Economics
Jinqiang Yang: Shanghai University of Finance and Economics
Zhentao Zou: Shanghai University of Finance and Economics

Economic Theory, 2018, vol. 66, issue 1, No 5, 157 pages

Abstract: Abstract We extend the Holmstrom and Milgrom (Econometrica 55:303–328, 1987) model by introducing model uncertainty to study robust long-term contracting and focus on relative performance evaluation. Concerns regarding model misspecification induce a tradeoff between incentives and ambiguity sharing, which increases the pay-performance sensitivity. When compensation contracts can be written on some additional signal, such as industry average performance, we find that an ambiguity-averse principal increases the agent’s exposure to the common shock by reducing the use of relative performance evaluation. Thus, optimal contracting involves effectively paying for luck and our model provides a theoretical explanation for the well-documented lack of relative performance evaluation in CEO compensation from the perspective of model uncertainty.

Keywords: Relative performance evaluation; Reward for luck; Model uncertainty; Ambiguity sharing (search for similar items in EconPapers)
JEL-codes: D81 D86 J33 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (9)

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DOI: 10.1007/s00199-017-1056-x

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