Subjective Performance Evaluation and Collusion

In many employment relationships, employees ’ contributions to firm value are not con-tractible. Firms therefore need to use alternative mechanisms to provide their employees with incentives. This paper investigates and contrasts two alternatives for a firm to pro-vide effort incentives: (i) to subjectively evaluate the employee’s performance; and (ii), to delegate the performance evaluation to a supervisor as a neutral party. Supervision gener-ates contractible information about the employee’s performance, but could result in vertical collusion. This paper demonstrates that supervision can be optimal whenever firms cannot perfectly identify employees ’ contributions to firm value. This can be observed despite ensuring collusion-proofness is shown to impose additional cost on firms in form of too low-powered incentives and inefficiently high fixed payments to employees and supervi-sors. Thus, this paper provides a supplementary rationale for the dominance of multi-level organizational hierarchies in practise.