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Relational Contracts as a Foundation for Bonus Pools

Much of our thinking about (and criticism of) the relationship between pay and performance seems to be based on a standard principal-agent model of explicit contracting and individual incentives. In this paper, we instead study implicit contracting, team incentives for mutual monitoring (tacit cooperation), and the interactions between team and individual incentives and implicit and explicit contracting. Bonus pools, which are optimal in the single-period version of our model, reward poor performance. We identify a broader role for such rewards. Paying for poor performance also has desirable incentive properties in motivating mutual monitoring and in mitigating tacit collusion. In an extension of our model, we study the seemingly contradictory incentives provided by bonus pools for both cooperation and competition.