The Effects of Interim Performance Evaluations under Risk Aversion

This paper reconsiders the applicability of a recently posed theoretical result concerning the optimality of not providing interim performance evaluations to the agent when implementing a given amount of total effort. The model used by Lizzeri, Meyers and Persico (2002) under the assumption of a risk neutral agent restricted by limited liability is analyzed when the agent is risk averse to show that interim performance evaluations do matter in reducing contract costs. In particular, they enable the principal to transfer the burden of insuring the agent against risk to the agent herself. Hence, the same incentives can be provided without as much consumption smoothing once performance information is revealed. On the other hand, when the incentive scheme is fixed, the risk averse agent may find it optimal to exert a greater amount of effort when performance evaluations are not revealed so as to insure herself against the possible losses that come with unexpected bad outcomes.