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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. Camerer, Colin & Weigelt, Keith, 1988. "Experimental Tests of a Sequential Equilibrium Reputation Model," Econometrica, Econometric Society, vol. 56(1), pages 1-36, January.
  2. David K Levine, 1997. "Modeling Altruism and Spitefulness in Experiments," Levine's Working Paper Archive 2047, David K. Levine.
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  5. Fehr, Ernst & Kirchsteiger, George & Riedl, Arno, 1993. "Does Fairness Prevent Market Clearing? An Experimental Investigation," The Quarterly Journal of Economics, MIT Press, vol. 108(2), pages 437-59, May.
  6. Rabin, Matthew, 1993. "Incorporating Fairness into Game Theory and Economics," American Economic Review, American Economic Association, vol. 83(5), pages 1281-1302, December.
  7. Gary Charness & Matthew Rabin, 2003. "Understanding Social Preferences with Simple Tests," General Economics and Teaching 0303002, EconWPA.
  8. Anderhub, Vital & Gächter, Simon & Königstein, Manfred, 1999. "Efficient contracting and fair play in a simple principal-agent experiment," SFB 373 Discussion Papers 1999,82, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
  9. 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.
  10. Ernst Fehr & Simon Gachter & Georg Kirchsteiger, 1997. "Reciprocity as a Contract Enforcement Device: Experimental Evidence," Econometrica, Econometric Society, vol. 65(4), pages 833-860, July.
  11. 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.
  12. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  13. 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.
  14. 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.
  15. 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.
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Citations

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Cited by:
  1. Houser, Daniel & Xiao, Erte & McCabe, Kevin & Smith, Vernon, 2008. "When punishment fails: Research on sanctions, intentions and non-cooperation," Games and Economic Behavior, Elsevier, vol. 62(2), pages 509-532, March.
  2. Fehr, Ernst & Schmidt, Klaus M., 2004. "Fairness and incentives in a multi-task principal-agent model," Munich Reprints in Economics 20657, University of Munich, Department of Economics.
  3. Ernst Fehr & Susanne Kremhelmer & Klaus M. Schmidt, . "Fairness and the Optimal Allocation of Ownership Rights," IEW - Working Papers 224, Institute for Empirical Research in Economics - University of Zurich.
  4. Ernst Fehr & Klaus Schmidt, 2005. "The Rhetoric of Inequity Aversion- A Reply," NajEcon Working Paper Reviews 666156000000000616, www.najecon.org.
  5. 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.
  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. Andreoni,J., 2005. "Trust, reciprocity, and contract enforcement : experiments on satisfaction guaranteed," Working papers 7, Wisconsin Madison - Social Systems.
  8. Avner Shaked, 2005. "The Rhetoric of Inequity Aversion," Levine's Bibliography 666156000000000570, UCLA Department of Economics.

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