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On the Relative Performance of Linear vs. Piecewise-Linear-Threshold Intertemporal Incentives

TransAlta Corporation, Calgary, Alberta T2P 2M1, Canada
Anderson School of Management, University of California, Los Angeles, Los Angeles, California 90095
joseph.chen1{at}gmail.com
bruce.miller{at}anderson.ucla.edu

This paper employs numerical simulations to compare the relative performance of linear contracts with piecewise-linear-threshold contracts in the case where the agent chooses actions over time. These contracts are restricted to be functions of the ending value of aggregate output. We find strong evidence that only linear contracts need be considered in comparison with piecewise-linear-threshold contracts in the situation where cumulative output is only updated periodically and the agent's utility function is exponential. This finding holds even when there are only two periods and hence one change of action by the agent. However, we find that the best piecewise-linear-threshold contract is significantly superior to the best linear contract when the agent has a power utility function. These numerical simulations also call into question the use of a cap when the agent's compensation is based on the ending value of aggregate output and the agent's effort takes place over time.

Key Words: linear contracts; intertemporal incentives; dynamic programming; salesforce compensation
History: Received: July 12, 2006; accepted: May 9, 2009.