Effective Utility Functions from Organizational Target-Based Incentives

Publication Type: 
A.E. Abbas
J. Matheson
R. Bordley
Many companies set performance targets for their divisions to decentralize the decision-making process and communicate with outside investors. This paper analyzes the effects of performance targets on the decision-making behavior of the divisions. We introduce the notion of an ‘effective utility function’—a function that a division should use in its selection of projects if it wishes to maximize the probability of achieving its targets. We show that many target-based incentives induce S-shaped utility functions and discuss the organizational problems they may pose. We then show how an organization can set targets that induce expected utility maximization.