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Contracts, Fairness and Incentives

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  • Ernst Fehr
  • Klaus Schmidt

Abstract

We show experimentally that fairness concerns may have a decisive impact on both the actual and the optimal choice of contracts in a moral hazard context. Explicit incentive contracts that are optimal according to self-interest theory become inferior when some agents value fairness. Conversely, implicit bonus contracts that are doomed to fail among purely selfish actors provide powerful incentives and become superior when there are some fair-minded players. The principals understand this and predominantly choose the bonus contracts, even preferring a pure bonus contract over a contract that combines the enforcement power of explicit and implicit incentives. This contract preference is associated with the fact that explicit incentives weaken the enforcement power of implicit bonus incentives significantly. Our results are largely consistent with recently developed theories of fairness, which also offer interesting new insights into the interaction of contract choices, fairness and incentives.

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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 122247000000000148.

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Date of creation: 22 Apr 2004
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Handle: RePEc:cla:levrem:122247000000000148

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  1. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
  2. Matthew Rabin., 1992. "Incorporating Fairness into Game Theory and Economics," Economics Working Papers, University of California at Berkeley 92-199, University of California at Berkeley.
  3. Nalbantian, Haig & Schotter, Andrew, 1994. "Productivity Under Group Incentives: An Experimental Study," Working Papers, C.V. Starr Center for Applied Economics, New York University 94-04, C.V. Starr Center for Applied Economics, New York University.
  4. David K. Levine, 1998. "Modeling Altruism and Spitefulness in Experiment," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(3), pages 593-622, July.
  5. Fehr, Ernst & Kirchsteiger, George & Riedl, Arno, 1993. "Does Fairness Prevent Market Clearing? An Experimental Investigation," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 108(2), pages 437-59, May.
  6. Werner Güth & Manfred Königstein & Judit Kovács & Enikõ Zala-Mezõ, 2001. "Fairness Within Firms: The Case Of One Principal And Multiple Agents," Schmalenbach Business Review (sbr), LMU Munich School of Management, LMU Munich School of Management, vol. 53(2), pages 82-101, April.
  7. Bull, Clive & Schotter, Andrew & Weigelt, Keith, 1987. "Tournaments and Piece Rates: An Experimental Study," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 95(1), pages 1-33, February.
  8. Charness, Gary B & Rabin, Matthew, 2001. "Understanding Social Preferences With Simple Tests," University of California at Santa Barbara, Economics Working Paper Series qt0dc3k4m5, Department of Economics, UC Santa Barbara.
  9. Camerer, Colin & Weigelt, Keith, 1988. "Experimental Tests of a Sequential Equilibrium Reputation Model," Econometrica, Econometric Society, Econometric Society, vol. 56(1), pages 1-36, January.
  10. Vital Anderhub & Simon Gaechter & Manfred Koenigstein, . "Efficient Contracting and Fair Play in a Simple Principal-Agent Experiment," IEW - Working Papers 018, Institute for Empirical Research in Economics - University of Zurich.
  11. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  12. Werner Güth & Wolfgang Klose & Manfred Königstein & Joachim Schwalbach, 1998. "An experimental study of a dynamic principal-agent relationship," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 19(4-5), pages 327-341.
  13. Ernst Fehr & Simon Gachter & Georg Kirchsteiger, 1997. "Reciprocity as a Contract Enforcement Device: Experimental Evidence," Econometrica, Econometric Society, Econometric Society, vol. 65(4), pages 833-860, July.
  14. Chaudhuri, Ananish, 1998. "The ratchet principle in a principal agent game with unknown costs: an experimental analysis," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 37(3), pages 291-304, November.
  15. Keser, Claudia & Willinger, Marc, 2000. "Principals' principles when agents' actions are hidden," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 18(1), pages 163-185, January.
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Citations

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Cited by:
  1. Fehr, Ernst & Schmidt, Klaus M., 2004. "Fairness and incentives in a multi-task principal-agent model," Munich Reprints in Economics, University of Munich, Department of Economics 20657, University of Munich, Department of Economics.
  2. James Andreoni, 2005. "Trust, Reciprocity, and Contract Enforcement: Experiments on Satisfaction Guaranteed," Levine's Bibliography 666156000000000679, UCLA Department of Economics.
  3. Fehr, Ernst & Kremhelmer, Susanne & Schmidt, Klaus M., 2004. "Fairness and the Optimal Allocation of Ownership Rights," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 11, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  4. Teck H. Ho & Noah Lim & Colin Camerer, 2005. "Modeling the Psychology of Consumer and Firm Behavior with Behavioral Economics," Levine's Bibliography 784828000000000476, UCLA Department of Economics.
  5. Avner Shaked, 2005. "The Rhetoric of Inequity Aversion," Levine's Bibliography 666156000000000570, UCLA Department of Economics.
  6. Daniel Houser & Erte Xiao & Kevin McCabe & Vernon Smith, 2005. "When punishment fails: Research on sanctions, intentions and non- cooperation," Experimental, EconWPA 0503001, EconWPA.
  7. Ernst Fehr & Klaus M. Schmidt, 2005. "The Rhetoric of Inequity Aversion – Reply," Levine's Bibliography 666156000000000574, UCLA Department of Economics.
  8. Fehr, Ernst & Schmidt, Klaus M., 2005. "The Economics of Fairness, Reciprocity and Altruism – Experimental Evidence and New Theories," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 66, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.

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