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Fairness, Incentives and Contractual Incompleteness

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  • Fehr, Ernst
  • Klein, Alexander
  • Schmidt, Klaus M.

Abstract

We show that concerns for fairness may have dramatic consequences for the optimal provision of incentives in a moral hazard context. Incentive contracts that are optimal when there are only selfish actors become inferior when some agents are concerned about fairness. Conversely, contracts that are doomed to fail when there are only selfish actors provide powerful incentives and become superior when there are also fair-minded players. These predictions are strongly supported by the results of a series of experiments. Furthermore, our results suggest that the existence of fair actors may be an important reason why many contracts are left deliberately incomplete.

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Bibliographic Info

Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 18.

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Date of creation: Jan 2001
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Handle: RePEc:lmu:muenec:18

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Keywords: Incentive Contracts ; Moral Hazard ; Fairness ; Reciprocity ; Incomplete Contracts;

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  1. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Econometrica, Econometric Society, vol. 62(2), pages 257-82, March.
  2. Ernst Fehr & Klaus M. Schmidt, 1999. "A Theory Of Fairness, Competition, And Cooperation," The Quarterly Journal of Economics, MIT Press, vol. 114(3), pages 817-868, August.
  3. Bernheim, B Douglas & Whinston, Michael D, 1998. "Incomplete Contracts and Strategic Ambiguity," American Economic Review, American Economic Association, vol. 88(4), pages 902-32, September.
  4. Gary Charness & Matthew Rabin, 2000. "Social Preferences: Some Simple Tests and a New Model," Econometric Society World Congress 2000 Contributed Papers 1483, Econometric Society.
  5. Segal, Ilya, 1999. "Complexity and Renegotiation: A Foundation for Incomplete Contracts," Review of Economic Studies, Wiley Blackwell, vol. 66(1), pages 57-82, January.
  6. Ernst Fehr & Simon Gachter & Georg Kirchsteiger, 2001. "Reciprocity as a Contract Enforcement Device," Levine's Working Paper Archive 563824000000000143, David K. Levine.
  7. Oliver Hart & John Moore, 1998. "Foundations of Incomplete Contracts," Harvard Institute of Economic Research Working Papers 1846, Harvard - Institute of Economic Research.
  8. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Scholarly Articles 12375014, Harvard University Department of Economics.
  9. Rabin, Matthew, 1993. "Incorporating Fairness into Game Theory and Economics," American Economic Review, American Economic Association, vol. 83(5), pages 1281-1302, December.
  10. W. Bentley MacLeod & James M. Malcomson, 1986. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment," Working Papers 585, Queen's University, Department of Economics.
  11. Falk, Armin & Fischbacher, Urs, 2001. "A Theory of Reciprocity," CEPR Discussion Papers 3014, C.E.P.R. Discussion Papers.
  12. Nöldeke, Georg & Schmidt, Klaus M., 1995. "Option contracts and renegotiation: A solution to the Hold-Up Problem," Munich Reprints in Economics 19329, University of Munich, Department of Economics.
  13. Dufwenberg, Martin & Kirchsteiger, Georg, 2004. "A theory of sequential reciprocity," Games and Economic Behavior, Elsevier, vol. 47(2), pages 268-298, May.
  14. Schmidt, Klaus M. & Schnitzer, Monika, 1995. "The interaction of explicit and implicit contracts," Economics Letters, Elsevier, vol. 48(2), pages 193-199, May.
  15. Aaron S. Edlin & Stefan Reichelstein, 1995. "Holdups, Standard Breach Remedies, and Optimal Investment," NBER Working Papers 5007, National Bureau of Economic Research, Inc.
  16. Ernst Fehr & Klaus M. Schmidt, . "Theories of Fairness and Reciprocity - Evidence and Economic Applications," IEW - Working Papers 075, Institute for Empirical Research in Economics - University of Zurich.
  17. Axel Ockenfels & Gary E. Bolton, 2000. "ERC: A Theory of Equity, Reciprocity, and Competition," American Economic Review, American Economic Association, vol. 90(1), pages 166-193, March.
  18. George Baker & Robert Gibbons & Kevin J. Murphy, 1993. "Subjective Performance Measures in Optimal Incentive Contracts," NBER Working Papers 4480, National Bureau of Economic Research, Inc.
  19. Donald B. Hausch & Yeon-Koo Che, 1999. "Cooperative Investments and the Value of Contracting," American Economic Review, American Economic Association, vol. 89(1), pages 125-147, March.
  20. Ernst Fehr & Armin Falk, 2003. "Wage Rigidity in a Competitive Incomplete Contract Market," Labor and Demography 0305001, EconWPA.
  21. Allen, F. & Gale, D., 1990. "Measurement Distortion And Missing Contingencies In Optimal Contracts," Weiss Center Working Papers 26-90, Wharton School - Weiss Center for International Financial Research.
  22. Gary E Bolton & Axel Ockenfels, 1997. "A Theory of Equity, Reciprocity, and Competition," Levine's Working Paper Archive 1889, David K. Levine.
  23. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
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