In Search of Informed Discretion: An Experimental Investigation of Fairness and Trust Reciprocity

Abstract

This paper investigates managerial discretion in compensation decisions in a team (i.e., joint production) setting. Specifically, we investigate the conditions under which managers tasked with allocating a discretionary bonus pool are willing to incur a personal cost to obtain ex post non-contractible information about the individual effort levels of of team members. Using theory from behavioral economics that incorporates preferences for fairness into the manager’s utility function, we predict and demonstrate experimentally that managers’ willingness to incur such a cost increases as the team’s aggregate performance becomes less extreme (i.e., as the team’s aggregate performance becomes a more noisy measure of individual performance). Further, using theory that incorporates preferences for trust reciprocity into the manager’s utility function, we predict and demonstrate experimentally that managers’ willingness to incur the cost will be greater for relatively high vs. relatively low levels of aggregate performance. The study contributes to the existing literature on subjective performance evaluation by identifying how social preferences influence managers’ use of discretion in evaluation processes.

Keywords: subjective performance evaluation, incentive contracting, discretion, reciprocity, fairness, trust, third-party intervention

JEL Classification: M40, M50, M52