Measurement Error, Manipulation, and the Value of Short‐Term Performance in Job Retention

ABSTRACT This paper studies how the accuracy of a short‐term performance measure affects its value when a principal decides whether to retain or fire an agent, who can manipulate that measure. Compared with ignoring performance and never firing the agent, the performance measure is valuable when the savings in the expected cost of the retention error is more than the expected cost of the firing error. A more accurate performance measure can have a non‐monotonic effect on its value: Greater accuracy improves the principal's ability to correctly identify the agent, which increases efficient firing, but it causes the incompetent agent to increase manipulation to avoid being fired, which increases inefficient retention. With a less accurate performance measure, the incompetent agent has weaker incentives for manipulation, and an increase in accuracy increases its value due to the identification effect. With a more accurate performance measure, the manipulation effect dominates, and an increase in accuracy decreases its value. The results imply that the principal prefers an imperfect performance measure when the agent can choose the level of manipulation.