Rene Kirkegaard (University of Guelph)
Abstract
Economic agents are motivated to undertake costly actions by the prospect of being rewarded for successes and punished for failures. But what determines what a success looks like? This paper endogenizes the criteria for success in an otherwise standard principal-agent model with a risk-neutral agent protected by limited liability. A contract now defines not only what the reward for success is, but also what constitutes a success in the first place. Under certain regularity assumptions, the more difficult it is to succeed, the fewer actions can be implemented. However, implementation costs decrease for those actions that remain implementable. Thus, the criteria for success can be used to manipulate implementation costs. If the criteria are of interest to the principal for only this reason, then the second-best action exceeds the first-best action. The opposite conclusion arises if the principal faces a budget constraint but all actions are implementable regardless of the criteria for success. When the principal's payoff depends directly and sufficiently strongly on the criteria of success themselves, then the second-best solution features either more stringent criteria for success or a lower action (or both) than the first-best solution.