Discretionary Bonuses as a Feedback Mechanism

Abstract

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. Consistent 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. 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.

Keywords: discretionary rewards, feedback, self confidence, subjective performance, moral hazard, monitoring system