Abstract
This paper studies a principal–agent relation in which the principal’s private information about the agent’s effort choice is more accurate than a noisy public performance measure. For some contingencies the optimal contract has to specify ex post inefficiencies in the form of inefficient termination (firing the agent) or wasteful activities that are formally equivalent to third-party payments (money burning). Under the optimal contract, the use of these instruments depends not only on the precision of public information but also on job characteristics. Money burning is used at most in addition to firing and only if the loss from termination is small. The agent’s wage may depend only on the principal’s report and not on the public signal. Nonetheless, public information is valuable as it facilitates truthful subjective evaluation by the principal.
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