Discretionary rewards as a feedback mechanism

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.

Keywords: Discretionary rewards; Feedback; Self confidence; Subjective performance; Moral hazard