Credible Threats, Reputation and Private Monitoring. ∗

In principal-agent relationships, a termination threat is often thought to be an effective way to provide the agent with incentives to sustain high effort. We examine the credibility of termination threats in a setting where the principal only receives private signals concerning the other party’s (i.e. the agent’s) effort level. We also assume that with small probability, the principal is weak: termination is very costly for him. We show that the principal cannot avoid building a reputation from being a weak type, and as a result, there can be no equilibrium where the threat to terminate is credible, hence no equilibrium where the agent makes high effort. 1