RELATIONAL CONTRACTS WITH SUBJECTIVE PEER EVALUATIONS∗

Abstract. Team-based work practices are ubiquitous, and most organizations collect infor-mation about an individual’s performance from his team-mates through privately reported peer evaluations. We analyze the optimal use of peer evaluations in the provision of in-centives.We derive the optimal contract in a setting in which the firm pays a discretionary bonus based on a publicly observed team output but may further sharpen incentives by using peer evaluations. The optimal contract illustrates why, when and how should peer evaluations be used. We show that peer evaluations can help sustain relational contracts. Peer evaluations are used when the firm is impatient and the associated surplus destruction is small. Moreover, peer reports affect a worker’s pay only when the public output is the lowest possible and he receives the worst possible peer report. Interestingly, a worker’s re-port does not affect his own pay. Effort incentives cannot be decoupled from truth-telling incentives, and in order to induce both effort and truthful peer reports, it may be optimal to ignore signals that are informative of the worker’s effort. Our results are consistent with compensation policy in many professional services industries such as the financial sector. 1