Abstract
We study multi-period sales-force incentive contracting where salespeople can engage in effort gaming, a phenomenon that has extensive empirical support. Focusing on a repeated moral hazard scenario with two independent periods and a risk-neutral agent with limited liability, we conduct a theoretical investigation to understand which effort profiles the firm can expect under the optimal contract. We show that various effort profiles that may give the appearance of being sub-optimal, such as postponing effort exertion (“hockey stick”) and not exerting effort after a bad or a good initial demand outcome (“giving up” and “resting on laurels,” respectively) may indeed be induced optimally by the firm. The reason is that, under certain conditions that depend on how severe the contracting frictions are and how effective effort exertion is in increasing demand, the firm wants to concentrate rewards on extreme demand outcomes; this induces gaming and reduces expected demand, but also makes motivating effort cheaper thus saving on incentive payments. On introducing dependence between time periods, such as when the agent can transfer demands between periods, this insight continues to hold and, furthermore, “hockey stick,” “giving up” and “resting on laurels” can be optimal for the firm even under repeated short time horizon contracting. Our results imply that one must carefully consider the setting and environmental factors when making inferences about contract effectiveness from dynamic effort profiles of agents.