Date of Original Version

12-2008

Type

Working Paper

Abstract or Table of Contents

In this paper, we model two drivers which underlie the economic trade-off shareholders face in designing incentives for optimal effort allocation by managers. The first driver is limited managerial attention, by which we mean that performing one task may have an adverse effect on the cost-efficiency of performing another. The second is the presence of a performance reporting task, by which we mean the manager’s ability to exert personally costly effort to improve the precision (or quality) of his/her performance measures. We show that the subtle interactions of the two drivers may alter the characteristics of incentive provision. First, we show the interaction may lead to a positive relation between the strength of the incentive and the endogenous variance of the performance measures. Second, the interaction may render an otherwise informative performance signal unused in equilibrium incentive contracts. We show two cases in which an informative signal is unused, for two distinct reasons. In one case the principal does not use the signal whose precision can be improved by the manager, in order to discourages the manager from diverting attention to the performance reporting task (which makes the productive effort more costly). In another case with asymmetric information about the nature of the performance measurement system, the principal may discard the signal which cannot be influenced by the manager in order to encourage a truthful self-report by the manager.