Interim Performance Evaluation in Contract Design
We thank the editor David Myatt and two anonymous referees for very useful comments and suggestions. We also thank Kalyan Chatterjee, Stephen Ching, Jacques Crémer, Jin Li, Jianpei Li, Sanxi Li, Ping Lin, Jeffrey Reuer, Wing Suen, Zhigang Tao, Frances Xu and participants in the 2010 Econometric Society World Congress (Shanghai) and other seminars held at CUHK, HKU, and Seoul National University for helpful comments. Financial support from the Guangdong Natural Science Foundation (S2012040007983), Guangdong Provincial Science and Technology Project (2011B061200008) and HKRGC (GRFs HKU74291B and HKU742709H) are acknowledged. All remaining errors are our own.
We study a principal–agent problem with sequential efforts and limited liability. An interim performance evaluation (IPE) allows the principal to learn the success of earlier efforts with some noise. We find conditions under which it is desirable to conduct such an IPE. A trade-off is identified between the beneficial effect of the agent's morale being boosted by a positive IPE outcome and the harmful effect of his morale being damaged by a negative one. We study both objective and subjective IPEs and characterise in each scenario the optimal contract and compare the corresponding effort plan with the first-best effort plan.