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Use and abuse of authority: A behavioral foundation of the employment relation

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  • Björn Bartling
  • Ernst Fehr
  • Klaus M. Schmidt

Abstract

Employment contracts give a principal the authority to decide flexibly which task his agent should execute. However, there is a tradeoff, first pointed out by Simon (1951), between flexibility and employer moral hazard. An employment contract allows the principal to adjust the task quickly to the realization of the state of the world, but he may also abuse this flexibility to exploit the agent. We capture this tradeoff in an experimental design and show that principals exhibit a strong preference for the employment contract. However, selfish principals exploit agents in one-shot interactions, inducing them to resist entering into employment contracts. This resistance to employment contracts vanishes if fairness preferences in combination with reputation opportunities keep principals from abusing their power, leading to the widespread, endogenous formation of efficient long-run employment relations. Our results inform the theory of the firm by showing how behavioral forces shape an important transaction cost of integration – the abuse of authority – and by providing an empirical basis for assessing differences between the Marxian and the Coasian view of the firm, as well as Alchian and Demsetz’s (1972) critique of the Coasian approach.

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Paper provided by Department of Economics - University of Zurich in its series ECON - Working Papers with number 098.

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Date of creation: Nov 2012
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Handle: RePEc:zur:econwp:098

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Keywords: Theory of the firm; transaction cost economics; authority; power abuse; employment relation; fairness; reputation;

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  1. Brown, Martin & Falk, Armin & Fehr, Ernst, 2008. "Competition and Relational Contracts: The Role of Unemployment as a Disciplinary Device," IZA Discussion Papers 3345, Institute for the Study of Labor (IZA).
  2. Stefan Grosse & Louis Putterman & Bettina Rockenbach, 2011. "Monitoring In Teams: Using Laboratory Experiments To Study A Theory Of The Firm," Journal of the European Economic Association, European Economic Association, vol. 9(4), pages 785-816, 08.
  3. Masten, Scott E, 1984. "The Organization of Production: Evidence from the Aerospace Industry," Journal of Law and Economics, University of Chicago Press, vol. 27(2), pages 403-17, October.
  4. Oliver Hart & John Moore, 2007. "Contracts as Reference Points," ESE Discussion Papers 170, Edinburgh School of Economics, University of Edinburgh.
  5. Ernst Fehr & Oliver Hart & Christian Zehnder, 2008. "Contracts as reference points – experimental evidence," IEW - Working Papers 393, Institute for Empirical Research in Economics - University of Zurich.
  6. Bartling, Björn & Schmidt, Klaus M., 2012. "Reference Points in Renegotiations: The Role of Contracts and Competition," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 385, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  7. Robert Gibbons, 2010. "Transaction-Cost Economics: Past, Present, and Future?," Scandinavian Journal of Economics, Wiley Blackwell, vol. 112(2), pages 263-288, 06.
  8. Urs Fischbacher, 2007. "z-Tree: Zurich toolbox for ready-made economic experiments," Experimental Economics, Springer, vol. 10(2), pages 171-178, June.
  9. Matthew Rabin., 1992. "Incorporating Fairness into Game Theory and Economics," Economics Working Papers 92-199, University of California at Berkeley.
  10. Casey Ichniowski & Kathryn Shaw, 2003. "Beyond Incentive Pay: Insiders' Estimates of the Value of Complementary Human Resource Management Practices," Journal of Economic Perspectives, American Economic Association, vol. 17(1), pages 155-180, Winter.
  11. Kirk Monteverde & David J. Teece, 1982. "Supplier Switching Costs and Vertical Integration in the Automobile Industry," Bell Journal of Economics, The RAND Corporation, vol. 13(1), pages 206-213, Spring.
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Cited by:
  1. Carpenter, Jeffrey P. & Dolifka, David, 2013. "Exploitation Aversion: When Financial Incentives Fail to Motivate Agents," IZA Discussion Papers 7499, Institute for the Study of Labor (IZA).

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