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Contracts, Fairness, and Incentives

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

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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Bibliographic Info

Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 334.

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Date of creation: Apr 2004
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Handle: RePEc:lmu:muenec:334

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Keywords: Moral Hazard; Incentives; Bonus Contract; Fairness; Inequity Aversion;

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References

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  1. 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, vol. 53(2), pages 82-101, April.
  2. 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.
  3. Bengt Holmstrom, 1981. "Moral Hazard in Teams," Discussion Papers 471, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Camerer, Colin & Weigelt, Keith, 1988. "Experimental Tests of a Sequential Equilibrium Reputation Model," Econometrica, Econometric Society, vol. 56(1), pages 1-36, January.
  5. Ananish Chaudhuri, 1997. "The Ratchet Principle in a Principal Agent Game with Unknown Costs: An Experimental Analysis," Departmental Working Papers 199608, Rutgers University, Department of Economics.
  6. Georg Kirchsteiger & Ernst Fehr & Simon Gächter, 1997. "Reciprocity as a contract enforcement device: experimental evidence," ULB Institutional Repository 2013/5911, ULB -- Universite Libre de Bruxelles.
  7. Bull, Clive & Schotter, Andrew & Weigelt, Keith, 1987. "Tournaments and Piece Rates: An Experimental Study," Journal of Political Economy, University of Chicago Press, vol. 95(1), pages 1-33, February.
  8. 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.
  9. 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.
  10. Charness, Gary & Rabin, Matthew, 2001. "Understanding Social Preferences with Simple Tests," Department of Economics, Working Paper Series qt4qz9k8vg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  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. Matthew Rabin., 1992. "Incorporating Fairness into Game Theory and Economics," Economics Working Papers 92-199, University of California at Berkeley.
  13. Georg Kirchsteiger & Ernst Fehr & Arno Riedl, 1993. "Does Fairness Prevent Market Clearing? An Experimental Investigation," ULB Institutional Repository 2013/5927, ULB -- Universite Libre de Bruxelles.
  14. Keser, Claudia & Willinger, Marc, 2000. "Principals' principles when agents' actions are hidden," International Journal of Industrial Organization, Elsevier, vol. 18(1), pages 163-185, January.
  15. Nalbantian, Haig R & Schotter, Andrew, 1997. "Productivity under Group Incentives: An Experimental Study," American Economic Review, American Economic Association, vol. 87(3), pages 314-41, June.
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Citations

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Cited by:
  1. James Andreoni, 2005. "Trust, Reciprocity, and Contract Enforcement: Experiments on Satisfaction Guaranteed," Levine's Bibliography 666156000000000679, UCLA Department of Economics.
  2. Fehr, Ernst & Kremhelmer, Susanne & Schmidt, Klaus M., 2005. "Fairness and the Optimal Allocation of Ownership Rights," CEPR Discussion Papers 5369, C.E.P.R. Discussion Papers.
  3. Ernst Fehr & Klaus Schmidt, 2005. "The Rhetoric of Inequity Aversion- A Reply," NajEcon Working Paper Reviews 666156000000000616, www.najecon.org.
  4. Ernst Fehr & Klaus M. Schmidt, . "Fairness and Incentives in a Multi-Task Principal-Agent Model," IEW - Working Papers 191, Institute for Empirical Research in Economics - University of Zurich.
  5. Avner Shaked, 2005. "The Rhetoric of Inequity Aversion," Levine's Bibliography 666156000000000570, UCLA Department of Economics.
  6. 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.
  7. Daniel Houser & Erte Xiao & Kevin McCabe & Vernon Smith, 2005. "When punishment fails: Research on sanctions, intentions and non- cooperation," Experimental 0503001, EconWPA.
  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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