Babbling Principals - the Problem of Information Transmission

Should principals communicate with their agents, explain and justify their evaluations? Economic research of communication and information transmission in organizations has usually focused on how to give agents incentives to gather information and how to elicit them truthfully. Yet also principals spend much time talking to their agents, not only giving instructions and evaluations, but also explaining and justifying them. This paper shows that it can be optimal for the principal to explain her subjective evaluation to the agent and make it understandable, even if communication is costly. The explanations are valuable, although they convey no additional information about the agent's effort and take place after the effort choice of the agent. The communication allows making the optimal contract contingent on the evaluation in a more refined way. Therefore it becomes possible to give the agent the right incentives at lower costs, because he understands the evaluation of his work better and learns, whether it is trustworthy. However a commitment issue arises, that can become quite costly. This might explain why evaluations and other kinds of feedback are often highly structured and institutionalized. Furthermore, the optimal contract is stochastic and bilateral, i.e. payments to third parties are not required to implement the optimal contract.