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60 CHAPTER 3. NOISE REDUCTION EFFECTIVENESS
3.1 Introduction
This chapter empirically assesses one of the fundamental claims of Relative Performance
Evaluation theory: the causal relation between RPE use and the reduction of noise in the
performance evaluation of employees. Noise decreases the performance metrics’ informativeness
about the efforts of the employee. Noise occurs if uncontrollable events affect the
measured performance. Noisy performance measures do not purely reflect the efforts of the
employee, as they are also affected by windfall gains and losses caused by uncontrollable
events. For example, consider the situation of a sales-manager operating in a stagnating
market. The uncontrollable market conditions reduce the sales manager’s revenues.
Although he zealously attempts to boost his sales, the manager’s performance indicators
suggest that he provided much less effort than last year, when the market conditions were
favourable. In this situation external events (in casu: the stagnating market) reduce the
manager’s performance score. However, the opposite effect is also possible when the conditions
are highly favourable. In both scenarios, noise results in a less functional performance
measurement system, as it informs the principal less accurately with regard to the agent’s
efforts. This reduces the efficiency of the performance contract between the principal and
the agent by imposing risk on the agent of not being rewarded for effort but for luck.
According to agency reasoning, RPE can restore the quality of the performance evaluation
by filtering out noise from the evaluated manager’s measured performance (Holmstrom
1982, Gibbons & Murphy 1990). RPE reduces noise by incorporating information about
the attainable performance level into the evaluated manager’s performance evaluation.
This works because of peer comparison (Holmstrom 1982). RPE compares the manager’s
actual performance to the performance of a reference group that partially faces the same
external events (i.e., market stagnation and dropping revenues). Thus, the performance of
the reference group is impacted in a similar manner by shared external events. The performance
of the reference group in a given period, with its specific external events, informs
the principal about the performance level that should be attainable for the agent in that
period. The comparison with peer performance constructs a performance norm that is (at
least partially) insulated from the impact of external events.
This causal relation between RPE use and noise in the performance evaluation is a cornerstone
explanation for why organizations would use RPE. This noise-reduction explanation
is prevalent in two streams of literature. The first stream is the analytical agency literature.
In a seminal paper, Holmstrom (1982) shows that RPE reduces noise in the performance
evaluation if benchmarked agents face some common uncertainties.
According to Holmstrom’s analyses, RPE filters out the effects of common uncertainties
such that the evaluation yields less noisy information about the agent’s performance.