Optimal contracts based on subjective evaluations and reciprocity

As demonstrated in a recent laboratory experiment [see Sebald and Walzl (2014)], individuals tend to sanction others who subjectively evaluate their performance whenever this assessment falls short of the individuals’ self-evaluation. Interestingly, this is the case even if the individuals’ earnings are unaffected by the subjective performance appraisal. Hence, performance feedback which falls short of agents’ self-evaluations can be interpreted as an unkind act that triggers a negatively reciprocal response not only if the assessment determines agents’ earnings but also when it lacks monetary consequences. We propose a principal-agent model formalizing that agents might engage into conflict in response to ego-threatening performance appraisals and show that these conflicts stabilize principal-agent relationships based on subjective performance evaluations. In particular, we identify conditions for a positive welfare effect of increasing costs of conflict and a negative welfare effect of more capable agents.