Agency and Anxiety

In this paper, we introduce the psychological concept of anxiety into agency theory. An important benchmark in the anxiety literature is the inverted‐U hypothesis, which states that an increase in anxiety improves performance when anxiety is low, but reduces it when anxiety is high. We show that the inverted‐U hypothesis is consistent with evidence that high‐powered incentives can reduce the agent's optimal effort and expected performance. In equilibrium, however, a profit‐maximizing principal never offers such counterproductive incentives. We also show that the inverted‐U hypothesis can explain empirical anomalies related to monitoring, the informativeness principle, and the risk–reward tradeoff.