A Heuristic for Determining Budget-Based Contracts in Multi-Period Settings.

Abstract This paper analyzes the principal's choice of budget-based contracts in a multi-period setting. In particular, two budget-based contracts are considered in which performance standards are used to evaluate the cost performance of managers who are rewarded by predetermined bonus amounts: (1) a “bangbang” contract and (2) a conditional investigation contract. Agent preferences are assumed to be stochastic and time dependent to more faithfully capture multi-period agency conflicts. A simple, decision heuristic for the principal's choice of budget-based contracts in a multi-period setting is developed. The heuristic involves treating the agent's behavior as a stochastic variable that is related to the performance standard and minimizing the principal's expected long-run costs using a simple “steady-stateǜ Markovian solution. Numerical analyses suggest that the heuristic makes “reasonably” efficient trade-offs between budget-based contract parameters (bonus amounts and performance standards) relative to an optimal benchmark for the cost processes examined.