Performance standards and incentive pay in agency contracts

When the presence of limited liability restricts a principal from imposing monetary fines on an agent in case of poor performance, the principal might use other kinds of punishment threats to deter the agent from shirking. We show that under the optimal contract in this case, the principal sets a pe rformance standard and punishes the agent if the standard is not met, but r ewards the agent on a profit-sharing basis if the standard is significantly exceeded. The optimal choice of performance standards for such contracts i s discussed. It is shown that punishment threats, although inefficient, oft en help the principal to discipline the agent.