Relative Performance Evaluation and Limited Liability

Abstract

We analyze the role of relative performance evaluation when a principal has several agents, who face correlated shocks. If limited liability constraints are binding, relative performance evaluation may be of no value if the principal is restricted to symmetric contracts. However, with asymmetric contracts, where agents are induced to choose different effort levels, relative performance measures can be used in order to reduce informational rents. Relative performance evaluation is a way of reducing the rents of the high effort agent, who will in general be worse off than the low effort agent.