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The "Ratchet Principle" and Performance Incentives

1980; Volume: 11; Issue: 1 Linguagem: Inglês

10.2307/3003414

2326-3032

Martin L. Weitzman,

Economic theories and models

The use of current performance as a partial basis for setting future targets is an almost universal feature of economic planning. This principle, as it is sometimes called, creates a dynamic incentive problem for the enterprise. Higher rewards from better current performance must be weighed against the future assignment of more ambitious targets. In this paper I formulate the problem of the enterprise as a multiperiod stochastic optimization model incorporating an explicit feedback mechanism for target setting. I show that an optimal solution is easily characterized, and that the incentive effects of the ratchet principle can be fully analyzed in simple economic terms.