The "Ratchet Principle" and Performance Incentives

Issue: Spring 1980

Pages: pp. 302-308

Authors: Martin L. Weitzman

Title: The "Ratchet Principle" and Performance Incentives

Abstract: The use of current performance as a partial basis for setting future targets is an almost universal feature of economic planning. This "ratchet 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.

Managerial Economics (5120)
Market Structure: Industrial Organization and Corporate Strategy (6110)

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