The ratchet, tautness, and managerial behavior in soviet-type economies

Suppose a manager receives a fixed bonus for reaching a target plus an overfulfillment reward. Each period the target is fixed by the manager's superiors in a manner that takes into account past performance. This is the ratchet. Managers facing this incentive scheme will choose an activity level which takes into account the dynamic effects of current behavior on future earnings. The conventional wisdom contends that managers will understate capacity by producing below maximum potential. We show that this behavior occurs only under certain conditions. More importantly, we also show that the ratchet can be used to induce managers to reveal the growth rate of average capacity.