Objective and subjective indicators in long-term contracting

Abstract We study the optimal compensation contract in a dynamic moral hazard setting with limited liability and two stages of production. At the end of the first stage, both an objective signal (publicly observed) and a subjective signal (privately observed by the principal) realize, and they are informative of the second-stage productivity. We show that in the optimal long-term contract, the two signals are used interactively with three notable features. First, whereas the objective signal is always used in the optimal contract, the subjective signal is used only if the realized value of objective signal is below a cutoff. Second, the solicited effort may exhibit an upward distortion (relative to the first best) for an intermediate region of the objective signal realizations. Third, the use of subjectivity varies with a number of factors such as the signal quality and the severity of the moral hazard problem.

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