On Optimal Contracting with Subjective Evaluation

This paper extends the standard principal-agent model to allow for subjective evaluation. It is shown that the optimal contract entails the use of more compressed evaluations relative to the case with objective performance measures. The degree of compression increases as the correlation between the principal's and agent's beliefs decreases. It is possible for the agent to implement a contract with high power incentives, however this necessarily entails a high level of "conflict" in the relationship, with the optimal amount of compression resulting from trading off between performance incentives and the socially wasteful "conflict" that they create. The model is also used to show how a bias or discrimination against an individual can lead to lower wages and performance