Endogenous Precision of Performance Measures and Limited Managerial Attention

In this paper, we model two drivers which underlie the economic tradeoff shareholders face in designing incentives for optimal effort allocation by managers. The first driver is limited managerial attention, by which we mean that performing one task may have an adverse effect on the cost-efficiency of performing another. The second is the presence of a performance reporting task, by which we mean the manager’s ability to exert personally costly effort to improve the precision (or quality) of his/her performance measures. We show that the subtle interactions of the two drivers may alter the characteristics of incentive provision. First, we show the interaction may lead to a positive relation between the strength of the incentive and the variance of the performance measures. Second, the interaction may render an otherwise informative performance signal unused in equilibrium incentive contracts. In particular, we show that it is possible that the principal does not use the signal whose precision can be improved by the manager, in order to discourage the manager from diverting attention to the performance reporting task (which makes the productive effort more costly). Finally, we apply the model to a specific project-selection setting and show that in order to induce the agent to choose higher-risk-higher-return projects, the principal may need to raise the bonus rate when the project-selection choice is unobservable.