Monitoring, Performance Reviews, and Retaliation

We analyze the effects of retaliation on optimal contracts in a hierarchy consisting of a principal, a monitor, and an agent. With probability m, the monitor observes a signal about the agent’s effort and decides what to report to the principal. With probability [Formula: see text], the monitor only observes an uninformative default signal realization. The agent retaliates against the monitor and the principal whenever the monitor’s report reduces the agent’s payment from an endogenously determined default level. We show that the principal’s optimal contracting problem can be divided into two steps: First is an information acquisition stage. The principal chooses how much retaliation to tolerate, and more retaliation generates more informative signals (in the Blackwell sense) about the agent’s effort. Second, given the information acquired, the principal designs the optimal payment schemes, which pool moderately (potentially all) bad agent performances with the uninformative signal realization. The empirical literature documents that supervisors are reluctant to provide poor ratings and that performance reports are often inflated and compressed. We show that such a pattern in performance appraisals can arise as firms’ optimal responses to retaliation concerns. This paper was accepted by Joshua Gans, business strategy. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2023.01226 .