management system. In that case, there would be no benefit – only the cost of covering the administrative costs associated with developing the monitoring and management systems. On the other hand, if the negotiated performance target is too high, there could also be significant costs. The exact nature of the costs depends upon which one of two unattractive options the principal chooses to follow once it becomes apparent that the performance targets were set unrealistically high. If the principal chooses simply to waive any possible repercussions for the agents for not meeting the performance targets, this can undermine the credibility of the system. If the principal insists on holding agents to meeting the performance targets – no matter how unrealistic they were – this can breed resentment and adversely affect future productivity.

The task is further complicated by the fact that there is typically a cascading down of performance targets being set at a first level administrative unit (perhaps at a national or state level) down to a second and/or third level administrative unit (perhaps a district or a county). There is often considerable variation in the initial conditions and the potential for performance across the lower level administrative units, making it difficult or unreasonable to set identical performance targets across administrative units.

# 3.  Possible approaches

Performance targets are usually set as an absolute target for an agent to reach, which is known to the agent prior to the period where performance would be reviewed.<sup>5</sup> The absolute target may be specified for a level of the performance indicator or a change in the indicator.<sup>6</sup> It is not uncommon for an absolute target to be set simply at a value which is a given percentage above the previous value, or some average of the previous value of the chosen performance indicator. For example, the principal could request that the agents reach a performance level that is 5 percent higher than the previous value. The problem with this approach is that it does not take into account the different initial conditions that the agents face that could make it easier or harder to achieve the targets.

Ideally, one would want the probability of achieving the target to be due solely to effort. There should be no systematic tendency for an agent with a given set of characteristics to succeed or fail in reaching the target. However, it there are different initial conditions that are present and that do affect the probability of achieving the target, then not taking them into account in the setting of the target will generate a systematic pattern in ex post observations of whether the target is achieved or not. This notion – that setting a reasonable target would be consistent with there being no systematic relation between achieving the target and a circumstance outside the control of the agent – is very similar to the underlying principle that has been used to create a metric to measure the equality of opportunity (Barros et al, 2009). In section 4, we show how that metric can be used to assess the relative quality of different approaches to target-setting.

> 5 Barlevy and Neal (2011) propose a Pay for Percentile incentive plan  that is based on relative performance and not on attaining a performance level or change relative to a target.   A nice brief discussion of the plan is presented by Barlevy and Neal in VoxEU (see http://www.voxeu.org/index.php?q=node/7073)   This is discussed in more detail in section 6).

> 6 In the education sector, many school districts and researchers stress the importance of looking at both achievement (the level) and growth.  A nice interactive demonstration of both performance and growth information on schools for the Colorado State Department of Education can be found at http://www.schoolview.org/ColoradoGrowthModel.asp

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