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Wojciech Olszewski, Professor of Economics, Northwestern University
Robust Relational Contracts with Subjective Performance Evaluation
Abstract: We study a repeated principal-agent model with transferable utility, where the principal’s evaluation of the agent’s performance is subjective. Consequently, monitoring is noisy and private. We focus on equilibria that are robust to small payoff shocks. Existing constructions to support effort fail to be equilibria in the presence of payoff shocks – there is no equilibrium where the agent always exerts effort on the equilibrium path. Allowing the principal and agent to make simultaneous cheap-talk announcements at the end of each period makes some effort sustainable in a purifiable equilibrium. Payoffs arbitrarily close to fully efficient ones can be achieved in equilibrium if players are sufficiently patient. In contrast to earlier constructions, bonus targets are non-trivial and employee self-evaluation is critical.