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1.2. LITERATURE REVIEW 5
along two lines. First, RPE can provide the owner/top management with more complete
information about the performance of the manager. This makes the performance
evaluation less ‘noisy’. Second, RPE can reduce the room that the employee has to behave
opportunistically. In this section, the mechanics of both the noise-reduction and
opportunism-mitigating properties of RPE are introduced.
Relative Performance Evaluation has been recognized in the literature primarily for its
noise-reduction properties (Holmstrom 1982). Noise in the performance evaluation is
caused by factors beyond the employee’s control that affect his measured performance.
With noisy performance measures, factors beyond the control of the employee influence
whether he reaches his performance target. This external influence reduces the quality of
the performance evaluation, which aims to reward the employee for his provision of effort,
not for uncontrollable events. Reasoning from an analytical agency theoretical tradition,
Holmstrom (1982) proves that RPE reduces noise in the evaluation by incorporating information
about peer performance into the performance contract between the owner/top
management (in agency terminology, the principal) and the employee/middle manager
(designated as the agent in this relationship). The performance of the reference group is
informative about the quality of the agent’s performance, due to shared exposure to the
uncontrollable events. Comparing the performance of the agent to the reference group
partially filters out the effects of external uncontrollable factors. As a result of this noise
reduction, RPE improves the quality of performance evaluation.
Example Consider the hypothetical situation of a sales manager at the Japanese guitar
manufacturing company ‘Ibanez Guitars’ in the early 1990s. Due to the increasing popularity
of electronic dance music, playing the guitar became less popular. As a result, guitar
sales dropped, and Ibanez’s previously healthy company profits slowly vanished. The external
event (the changing musical preference) affected the performance evaluation of Ibanez’s
sales manager, who was rewarded based on his sales revenue. The changing music scene
did not only affect Ibanez’s performance. Other guitar companies suffered from dropping
revenues and profits too. The performance evaluation of the manager, which compared his
actual revenue to his sales budget, was noisy. This noise was due to the impact of external
events over which the manager had no control. This situation was not motivating for the
sales manager because his performance evaluation indicated decreasing performance every
year, no matter how much effort he put in. However, if the superior of Ibanez’s sales
manager had taken peer performance into account when evaluating the manager, the performance
evaluation would have given a more accurate impression of the sales manager’s
efforts. By judging the manager’s relative performance (i.e., his performance compared to
his peers), the evaluation would be insulated from the effects of society’s eroding musical
taste.