Relative importance of measures of past performance: Theory and evidence

To investigate the role of measures of past performance and accomplishments in determining compensation, I develop a principal-agent model where the agent's ability is not observed directly by the principal. To the extent managerial ability persists over time, past performance and accomplishments signal how the agent's innate ability is likely to affect future performance which; in turn, should affect his value to the firm as well as the wage level he can command in the labor market for his services. I show that the principal's optimal solution for employing and compensating the agent can be implemented by a simple take-it-or-leave-it offer mechanism in which the optimal compensation level can be expressed as a nonlinear function of two linear aggregates of measures of past performance. I show that the optimal aggregate measure places a greater weight on measures of past performance that are more precise and more sensitive to the agent's ability. The results are analogous to those in moral hazard models, but they stem from the posterior expectation about the agent's ability in creating value for the firm and in commanding a higher market price rather than the slope of the loglikelihood function in inferring his unobservable effort.; Next, I empirically investigate the relative importance of alternative measures of past performance that signal the quality of managers, workers or other service providers. I analyze the theoretical model of adverse selection to motivate empirical hypotheses about differences in the importance of various signals depending on the nature of the service. Growth of web-based markets enables the collection of an excellent set of quasi-experimental data to test those hypotheses. Specifically, I evaluate the importance of different quality signals in an online auction market for accounting services in the buyer's assessment of service provider quality. I identify various quality signals about accounting service providers who bid on bookkeeping and tax service projects posted at an e-marketplace. I find that signals based on the service providers' past performance have a significant impact on the buyers' award decisions and the service providers' subsequent success in a competitive market place. The results support theoretical predictions that signals pertaining to service providers' technical competence, such as professional certification, are more important for tax services than for bookkeeping services, whereas signals pertaining to service providers' quality in interacting with clients are important for both bookkeeping and tax services.