No. 181: The Role of Performance Aspiration in Incentive Design and Performance Evaluation

We investigate how employees’ aspirations to achieve desired performance outcomes affect incentive design and performance evaluation. We extend a principal/agent-model with moral hazard by assuming that the agent compares their performance to aspired reference points and is disappointed when their performance falls short of these points. These aspirations motivate the agent to exert effort, enabling the principal to provide weaker incentives. The optimal performance evaluation involves a performance target, whereby the principal acquires additional information if the agent’s performance falls below this target. The optimal performance target decreases in the agent’s aspirations. When the principal sets the agent’s reference points, we find that performance aspiration is less relevant for low-skilled jobs but highly relevant for knowledge-intensive, non- routine jobs where performance is difficult to measure. Overall, our theory suggests subtle interrelations between cultural and formal controls, such as firms’ incentive designs and the common practice of lower-tail monitoring to acquire performance-related information.