Interim Performance Evaluation in Contract Design

Abstract

This paper examines the desirability of having an interim performance evaluation (IPE) in the design of an optimal contract. While enabling the principal to plan and control the project process better, the IPE may also adversely affect the agent’s morale in case of unfavorable IPE outcome. Despite this, we show that it is without loss of generality using contracts that tailor effort or payment to the IPE result when it involves objective measures. In the environment in which it involves subjective measures, not using IPE may be in the principal’s interest; the reason is that the contract now features a progressive payment scheme that renders extra costs upon information disclosure.