Costs and benefits of discretion in performance evaluation and patterns of bias

This paper investigates incentive effects from subjective performance evaluation in an agency setting. A manager (agent) is evaluated by his superior (principal) via a subjective performance report. Naturally, the superior is able to distort the report. Assuming a fairness-sensitive manager, his response to a percieved reporting bias is not straightforward. His reaction to an undervaluation is always negative, his reaction to overvaluation, in contrast, not unequivocally positive, due to fairness issues. Within this setting, we
find that reporting discretion can be either bene
cial or detrimental to the principal. In particular, the option to bias renders incentive provision more costly but also reduces the agent's exposure to risk in the optimal contract. Moreover, we
find that frequently observed bias patterns such as centrality bias and leniency bias arise endogenously in our model.