Speak softly, but carry a big stick: On optimal targets under moral hazard |
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| Authors: | Kent Osband |
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| Affiliation: | 1. University of Virginia, United States;2. CONICET and Universidad Nacional de Cuyo;1. School of Management and Engineering, Nanjing University, Nanjing, Jiangsu 210093, China;2. School of Economics and Management, Tsinghua University, Beijing 100084, China;3. School of Management, Shanghai University of Engineering Science, Shanghai 201620, China;4. Faculty of Business, Athabasca University, Athabasca, Alberta T9S 3A3, Canada;5. Odette School of Business, University of Windsor, Windsor, Ontario N9B 3P4, Canada |
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| Abstract: | When managerial compensation is restricted to be constant below a certain target output level, and underlying effort is unobserved, a recent article by Liu suggests that the optimal sharing rule should be smooth and locally convex at the target. This is incorrect. If minimum payments are set exogenously, the optimal sharing rule for a risk-averse manager will be kinked at the target. If penalties are unbounded, the principal can approach the first-best full-information outcome by offering a constant payment under normal conditions but imposing a severe punishment for extremely unlikely low outcomes, i.e., by “speaking softly but carrying a big stick.” |
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