Optimality of Intertemporal Aggregation in Dynamic Agency

Abstract

Employee performance evaluations usually take place on an annual basis but quarterly, monthly, or weekly evaluations are by no means exceptional. If their outcomes determine variable pay, finding the optimal frequency of performance evaluations is far from a trivial task. This paper investigates the benefit of intertemporal aggregation of performance measures in a two-period agency with a non-stationary production technology and shows that infrequent evaluation can be efficient even if there is complementarity between tasks in different periods. When the principal cannot fully commit to a two-period contract, the benefit of aggregation is yet larger.

On interim performance evaluations and interdependent period outcomes

“…Analysis of outcome-dependent interaction effects is important because, as the example from above suggests, realized outcomes often provide essential clues to assess the future performance of business units. Moreover, even though Nikias et al (2005) and Lukas (2010) used a similar model setup, results prove to be sensible to the assumption whether first-period effort in general (Lukas, 2010) or only high effort in the first period (Nikias et al, 2005) impact the productivity and the chances of success in the second period. 2 The difference in results for effort-dependent interaction effects ensuing from a seemingly minor modification of the setup could suggest that consequences of outcome-dependent interaction effects with regard to the choice of the evaluation regime may not be conspicuous and differ from those of effort-dependent interaction effects.…”

“…The research presented herein deals with performance evaluation frequency and intertemporal aggregation of information in an agency. It is most closely related to analytical research by Lizzeri et al (2002); Arya et al (2004); Nikias et al (2005); Lukas (2010), and Chen and Chiu (2013). All authors studied the principal's choice between FPE and IPE in two-period settings and-except for Lizzeri et al (2002)employed an agency model with binary action choice and binary outcome distribution in each period.…”

“…1 Hence, firms exercise their option to generate and communicate performance information at varying frequencies. Two factors have been asserted to influence the choice of performance evaluation frequency: the interdependence of periods (Arya et al, 2004;Nikias et al, 2005;Lukas, 2010) and the actual usage of performance information (Feltham et al, 2006). Assume that periods are both technologically and stochastically independent, and the outcome distribution is binary.…”

“…Researchers must address this issue to guide firms. Nikias et al (2005) and Lukas (2010) considered (different) effort-dependent interaction effects between periods, i.e., the effort choice in a given period directly affected future effort choices and chances of success due to, e.g., learning effects or exhaustion. The present study deals with outcome-dependent interaction effects, which have not been analyzed in the literature.…”

“…In the first setting, the optimal course of 2 Specifically, weak positive complementarity between effort choices in period 1 and 2 leads to a weak preference for aggregate evaluation in Nikias et al (2005). However, the extent of positive complementarity matters in Lukas (2010). 3 Negative effects of higher performance evaluation frequency include gaming of the incentive system (Bouwens & Kroos, 2011) an increase of outcome effects (Frederickson et al, 1999), recency effects entailing less accurate earnings predictions (Pitre, 2012), cognitive overload, which in turn causes a decline in individual performance (Lurie & Swaminathan, 2009;Lam et al, 2011), or undesired behavior like manipulating information (Murphy, 2004;Jain, 2012).…”