Subjective Performance Evaluations, Collusion, and Organizational Design

Many scholars have emphasized the importance of subjective performance evaluations in employment relationships to provide employees with appropriate effort incentives. While the previous literature has focused on subjective evaluations conducted directly by the firm owner (principal), we investigate when delegating subjective appraisals to managers (su-pervisors) is optimal. Managers are equipped with the expertise to better evaluate employ-ees ’ contributions to firm value, but can be biased in their evaluation because of potential collusion. We find that delegating performance appraisals to managers is optimal when employees ’ potential contributions to firm value are relatively low. However, to ensure the impartiality of managers, their compensations must be higher than would otherwise be effi-cient, and effort incentives for their subordinates must be relatively low. In this proposition, the paper provides a rationale for the existence of hierarchical firm structures, the preva-lence of high wage differentials, and the use of low-powered incentives within hierarchical firms