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. The manager appreciates favorable
ratings but also despises arbitrary or inaccurate evaluations. Accordingly, 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. Within this
setting, we find that reporting discretion can be either beneficial or detrimental to the principal.
In particular, the option to bias renders incentive provision more costly but also reduces the
agent’s risk exposure and allows to control his evaluation response to the benefit of the firm.
Moreover, we find that frequently observed bias patterns such as centrality bias and leniency
bias arise endogenously in our model.