Theories Of Behavior In Principal-Agent Relationships With Hidden Action

In Keser and Willinger (IJIO, 2000) we found that many contracts offered by experimental subjects do not satisfy incentive compatibility. While the combination of incentive compatibility and a binding participation constraint would require that the agent incurs a net loss in the less favorable state for the principal, experimental subjects in the role of principals propose contracts in which the agent never risks to make a loss. We identified in the principals’ decision making three basic principles that, combined together, describe a fair offers area into which a large number of the observed contract offers falls. These principles imply that net expected surplus is more evenly allocated between the principal and the agent than agency theory predicts. The aim of the experiments presented in this paper is to test the robustness of these principles when the effort costs increase and the net expected surplus becomes smaller, and to compare their predictive success to the predictive success of agency theory under the assumption either of a risk-averse or a risk-neutral agent. The results show that the fair offers prediction describes the observed contract offers better than agency theory as long as an important net expected surplus is created. However, when the effort costs are so high that the net expected surplus is negligible, standard agency theory does better than the combination of the three principles in predicting the observed contract offers.