1I would like to thank Canice Prendergast for suggesting this problem and for helpful comments on a first draft. I also greatly appreciated the comments of Janet Currie and Jonathan Levin, and thank Mehdi Farsi for excellent This paper extends the standard principal-agent model to allow for subjective evaluation. It is shown that the optimal contract entails the use of more compressed evaluations relative to the case with verifiable performance measures. The optimal degree of compression trades off incentives against the costly conflict that arises when the principal and agent do agree regarding what constitutes appropriate performance. When applied to the problem of discrimination, it is shown that more able individuals in a discriminated against group may receive lower wages if they are less tolerant of discrimination. Finally, the optimal contract entails the use bonuses pay rather than the threat of dismissal, and hence efficiency wages are not in general Like the parents in Garrison Keillor’s Lake Woebegone, where all the children are above average, supervisors also have a tendency to judge their workers as above average, resulting in performance evaluations that are morecompressedandlessvariablethanactualperformance.Inthispaperitisshownthatsuchcompression is a feature of the optimal contract between a risk neutral principal and a risk averse agent when rewards are

It is well known that contract incompleteness can arise from the impossibility of planning for all future contingencies in a relationship (e.g. Williamson (1975)). In this paper it is shown that whether or not such incompleteness constrains the efficiency of the contract is very sensitive to assumptions concerning the timing of the resolution of uncertainty. It is shown that when agents must respond to an unforeseen contingency before being able to renegotiate the contract, then contract complexity is a binding constraint, a case that is called ex post hold-up. Secondly, it is suggested that the amount of multi-tasking can provide a measure of contract complexity. When complexity is low, contingent contracting is efficient, while subjective performance evaluation is more efficient when complexity is high. In this case the optimal contract for ex post hold-up is based upon the ability of humans to make subjective judgements that are in some cases more informative than explicit performance measures. Moreover, the efficiency of the contract is not sensitive to human error per se, but is an increasing function of the correlation in judgements between the contracting parties. ∗I very much appreciate the comments of the referees, Tom Lyon, Eric Rasmusen, Sherwin Rosen, Eric Tally, and Oliver

This paper discusses the literature on the enforcement of incomplete contracts. It compares legal enforcement to enforcement via relationships and reputations. A number of mechanisms, such as the repeat purchase mechanism (Klein and Leffler (1981)) and efficiency wages (Shapiro and Stiglitz (1984)), have been o ered as solutions to the problem of enforcing an incomplete contract. It is shown that the efficiency of these solutions is very sensitive to the characteristics of the good or service exchanged. In general, neither the repeat purchase mechanism nor efficiency wages is the most efficient in the set of possible relational contracts. In many situations, total output may be increased through the use of performance pay and through increasing the quality of law.

When gains from trade exist both along contractible and non-contractible dimensions and procurement is repeated, non-contractible gains from trade can be realized through reputa-tion/relational contracting. A buyer may restrict participation to his recurrent auctions to a subset of potential sellers and threaten replacement of sellers that perform poorly along non-contractible dimensions. In such a dynamic procurement framework, keeping the optimal num-ber of eligible sellers endogenous, we find that: a) there is a general trade-off between reputa-tion for quality and collusion: shorter contracts- more frequent re-auctioning- and restricted participation facilitate non-contractible quality provision, but also collusive agreements among suppliers; and b) when non-contractible quality and variability in suppliers ’ efficiency are both important, short contract duration and a collusive agreement between a few eligible sellers may maximize welfare and leave the buyer better off. JEL Classification Numbers:...

Many scholars have emphasized the importance of subjective performance evaluations in employment relationships to provide employees with appropriate effort incentives. While the previous literature has focused on subjective evaluations conducted directly by the firm owner (principal), we investigate when delegating subjective appraisals to managers (su-pervisors) is optimal. Managers are equipped with the expertise to better evaluate employ-ees ’ contributions to firm value, but can be biased in their evaluation because of potential collusion. We find that delegating performance appraisals to managers is optimal when employees ’ potential contributions to firm value are relatively low. However, to ensure the impartiality of managers, their compensations must be higher than would otherwise be effi-cient, and effort incentives for their subordinates must be relatively low. In this proposition, the paper provides a rationale for the existence of hierarchical firm structures, the preva-lence of high wage differentials, and the use of low-powered incentives within hierarchical firms.

This paper studies the use of discretionary rewards in a finitely repeated principal-agent relationship with moral hazard. The key aspect is that rewards have informational content. When the principal obtains a private subjective signal about the agent's performance, she may pay discretionary bonuses to provide credible feedback to the agent. In accordance with the often observed compression of ratings, we show that in equilibrium the principal communicates the agent's interim performance imperfectly, i.e., she does not fully differentiate good and bad performance. Furthermore, we show that small rewards can have a large impact on the agent's effort, provided that the principal's stake in the project is small.

In this paper we explore theoretically the relationship between explicit and implicit/relational contracting distinguishing between the ex-ante decision to sign an explicit contract and the ex-post decision wheter to actually apply it. We show, among other things, that the relational efficient explicit contract tends to display overcontracting on tasks or qualitative requirements (A) that are verifi-able but apparently of little use for the principal. The ex-post (non)implementation of such explicit contract can then be discretionally exchanged against the pro-vision of non contractible tasks (B) that are highly valuable for the principal. An empirical implication of the result, consistent with casual observation in pro-curement, is that penalties for infringements established by explicit contracts are seldom exercised, even though violations take place and are easy to monitor and verify. 1

We examine a contracting problem between a risk-neutral principal and an agent that is risk-neutral but liquidity constrained in a stochastically re-peated environment. The incentive scheme comprises two parts: contingent on the realization of a veri…able- i. e. court-enforceable- monitoring signal,

The Determinants of Salary and Bonus for Rank and File Employees The current study integrates the repeated game approach to implicit contracts and the analysis of explicit bonus rules based on subjective performance evaluation to determine the optimal structure of the compensation scheme for the average white-collar employee. In contrast to previous contributions we assume that the agent is risk-neutral but liquidity constrained. The salary reects the maximum reward associated with contractual compliance which can be implicitly agreed. If the prob-ability that the employee remains within the …rm increases, the principal can reduce the rent captured by the agent. Hence, the optimal salary increases and the bonus decreases. Nevertheless, the optimal e¤ort supply unambiguously increases.

In many employment relationships, employees ’ contributions to firm value are not con-tractible. Firms therefore need to use alternative mechanisms to provide their employees with incentives. This paper investigates and contrasts two alternatives for a firm to pro-vide effort incentives: (i) to subjectively evaluate the employee’s performance; and (ii), to delegate the performance evaluation to a supervisor as a neutral party. Supervision gener-ates contractible information about the employee’s performance, but could result in vertical collusion. This paper demonstrates that supervision can be optimal whenever firms cannot perfectly identify employees ’ contributions to firm value. This can be observed despite ensuring collusion-proofness is shown to impose additional cost on firms in form of too low-powered incentives and inefficiently high fixed payments to employees and supervi-sors. Thus, this paper provides a supplementary rationale for the dominance of multi-level organizational hierarchies in practise.