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Discretionary Bonuses as a Feedback Mechanism

  • Anton Suvorov

    ()

    (CEFIR and New Economic School)

  • Jeroen van de Ven

    ()

    (University of Amsterdam and Utrecht School of Economics)

This paper studies the use of discretionary rewards in a finitely repeated principal-agent relationship with moral hazard. We show that the principal, when she obtains a private subjective signal about the agent’s performance, may pay discretionary bonuses to provide credible feedback to the agent. Conistent 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 di?erentiate 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. Our analysis further reveals that, also in accordance with the empirical findings, the principal may ex ante prefer to choose a ’smoky’, rather than a fully transparent performance monitoring system, thereby acquiring an implicit commitment device to reward the agent through discretionary bonuses.

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Paper provided by Center for Economic and Financial Research (CEFIR) in its series Working Papers with number w0088.

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Length: 35 pages
Date of creation: Mar 2006
Date of revision:
Handle: RePEc:cfr:cefirw:w0088
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  1. Bentley MacLeod, 2001. "Optimal Contracting with Subjective Evaluation," Theory workshop papers 357966000000000036, UCLA Department of Economics.
  2. Alessandro Lizzeri & Margaret A. Meyer & Nicola Persico, 2002. "The Incentive Effects of Interim Performance Evaluations," Penn CARESS Working Papers 592e9328faf6e775bf331e1c0, Penn Economics Department.
  3. Roland Benabou & Jean Tirole, 2003. "Intrinsic and Extrinsic Motivation," Review of Economic Studies, Wiley Blackwell, vol. 70(3), pages 489-520, 07.
  4. Bengt Holmstrom, 1999. "Managerial Incentive Problems: A Dynamic Perspective," NBER Working Papers 6875, National Bureau of Economic Research, Inc.
  5. Pearce, David G. & Stacchetti, Ennio, 1998. "The Interaction of Implicit and Explicit Contracts in Repeated Agency," Games and Economic Behavior, Elsevier, vol. 23(1), pages 75-96, April.
  6. Bull, Clive, 1987. "The Existence of Self-Enforcing Implicit Contracts," The Quarterly Journal of Economics, MIT Press, vol. 102(1), pages 147-59, February.
  7. MacLeod, W Bentley & Malcomson, James M, 1989. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment," Econometrica, Econometric Society, vol. 57(2), pages 447-80, March.
  8. William Fuchs, 2005. "Contracting with Repeated Moral Hazard and Private Evaluations," 2005 Meeting Papers 431, Society for Economic Dynamics.
  9. Baker, George & Gibbons, Robert & Murphy, Kevin J, 1994. "Subjective Performance Measures in Optimal Incentive Contracts," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1125-56, November.
  10. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  11. Cho, In-Koo & Kreps, David M, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 179-221, May.
  12. Banks, Jeffrey S. & Sobel, Joel., 1985. "Equilibrium Selection in Signaling Games," Working Papers 565, California Institute of Technology, Division of the Humanities and Social Sciences.
  13. Jonathan Levin, 2003. "Relational Incentive Contracts," American Economic Review, American Economic Association, vol. 93(3), pages 835-857, June.
  14. Ernst Fehr & Simon Gachter & Georg Kirchsteiger, 2001. "Reciprocity as a Contract Enforcement Device," Levine's Working Paper Archive 563824000000000143, David K. Levine.
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