Subjective Performance Measures in Optimal Incentive Contracts*

Incentive contracts often include important subjective components that mitigate incentive distortions caused by imperfect objective measures. This paper explores the combined use of subjective and objective performance measures in (respectively) implicit and explicit incentive contracts. We show that the presence of sufficiently effective explicit contracts can render all implicit contracts infeasible, even those that would otherwise yield the first-best. We also show, however, that in some circumstances objective and subjective measures are complements: neither an explicit nor an implicit contract alone yields positive profit, but an appropriate combination of the two does. Finally, we consider subjective weights on objective measures. *We are very grateful for helpful discussions with Gary Becker, David Besanko, James Brickley, Bengt Holmström, Kevin Lang, George Milkovich, Kevin M. Murphy, Canice Prendergast, James Rebitzer, Andrei Shleifer, Richard Thaler, Karen Van Nuys, and Michael Waldman, as well as for useful comments from participants at numerous seminars. We also appreciate financial support from: the Division of Research at Harvard Business School (Baker and Murphy); and the NSF (SES-9010759) and an A. P. Sloan Research Fellowship (Gibbons). Subjective Performance Measures in Optimal Incentive Contracts by George Baker, Robert Gibbons, and Kevin J. Murphy