Optimal Relative Performance Evaluation

The theoretical prediction of a negative coe¢ cient on positively correlated peer performance that underlies much of the empirical literature on relative performance evaluation, is commonly obtained from the special case where variance-covariance matrix of the performance measures is exogenously restricted to be independent of the evaluee’s action. Using the dynamic approach of Holmström and Milgrom (1987). I study the properties of contracts that optimally condition an agent’s compensation both on his own performance and on how well he fares relative to a peer (group).when this restriction is not imposed. I show that the variance-covariance matrix is independent of the evaluee’s action if and only if the covariance is zero and relative performance evaluation therefore is not optimal. If the covariance is non-zero, I show that the optimal contract is linear in own performance and its correlation with peer performance while, in line with the preponderance of the empirical evidence, the expected coe¢ cient on peer performance is exactly zero. . N th preliminary and rough draft. Please do not circulate further or quote. I am grateful to Tod Cox for assistance with the graphical illustrations, to participants in the 2012 Stanford Summer Camp, the 2013 Utah Winter Conference, workshop participants at Hong Kong Polytechnic University, University of Zurich University of Michigan, Fucape Business School (Brazil), Eva Labro, Karen Nelson, Shiva Shivaramakrishnan, George Drymiotes and Ted Christensen for comments on earlier and roughere drafts. All remaining de…ciencies are exclusively attributable to me.