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Optimal contracts, adverse selection and social preferences: An experiment

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  • Antonio Cabrales
  • Gary Charness

Abstract

It has long been standard in agency theory to search for incentive-compatible mechanisms on the assumption that people care only about their own material wealth. However, this assumption is clearly refuted by numerous experiments, and we feel that it may be useful to consider nonpecuniary utility in mechanism design and contract theory. Accordingly, we devise an experiment to explore optimal contracts in an adverse-selection context. A principal proposes one of three contract menus, each of which offers a choice of two incentive-compatible contracts, to two agents whose types are unknown to the principal. The agents know the set of possible menus, and choose to either accept one of the two contracts offered in the proposed menu or to reject the menu altogether; a rejection by either agent leads to lower (and equal) reservation payoffs for all parties. While all three possible menus favor the principal, they do so to varying degrees. We observe numerous rejections of the more lopsided menus, and approach an equilibrium where one of the more equitable contract menus (which one depends on the reservation payoffs) is proposed and agents accept a contract, selecting actions according to their types. Behavior is largely consistent with all recent models of social preferences, strongly suggesting there is value in considering nonpecuniary utility in agency theory.

Suggested Citation

  • Antonio Cabrales & Gary Charness, 2000. "Optimal contracts, adverse selection and social preferences: An experiment," Economics Working Papers 478, Department of Economics and Business, Universitat Pompeu Fabra.
  • Handle: RePEc:upf:upfgen:478
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Sandra Maximiano & Randolph Sloof & Joep Sonnemans, 2007. "Gift Exchange in a Multi-Worker Firm," Economic Journal, Royal Economic Society, vol. 117(522), pages 1025-1050, July.
    2. Gary Charness & Martin Dufwenberg, 2006. "Promises and Partnership," Econometrica, Econometric Society, vol. 74(6), pages 1579-1601, November.
    3. Angelova, Vera & Güth, Werner & Kocher, Martin G., 2012. "Co-employment of permanently and temporarily employed agents," Labour Economics, Elsevier, vol. 19(1), pages 48-58.
    4. Gächter, Simon & Thöni, Christian, 2010. "Social comparison and performance: Experimental evidence on the fair wage-effort hypothesis," Journal of Economic Behavior & Organization, Elsevier, vol. 76(3), pages 531-543, December.
    5. Harbring, Christine & Irlenbusch, Bernd, 2005. "How Many Winners Are Good to Have? On Tournaments with Sabotage," IZA Discussion Papers 1777, Institute for the Study of Labor (IZA).
    6. Joel Sobel, 2009. "Generous actors, selfish actions: markets with other-regarding preferences," International Review of Economics, Springer;Happiness Economics and Interpersonal Relations (HEIRS), vol. 56(1), pages 3-16, March.
    7. Gary Charness & Peter Kuhn, 2007. "Does Pay Inequality Affect Worker Effort? Experimental Evidence," Journal of Labor Economics, University of Chicago Press, vol. 25, pages 693-723.
    8. Laurent Vilanova & Nadège Marchand & Walid Hichri, 2015. "Financing and advising with (over)confident entrepreneurs: an experimental investigation," Working Papers halshs-01154514, HAL.
    9. Charness, Gary & Dufwenberg, Martin, 2003. "Promises & Partnership," Research Papers in Economics 2003:3, Stockholm University, Department of Economics.

    More about this item

    Keywords

    Adverse selection; contract theory; experiment; principal-agent problem; Leex;

    JEL classification:

    • A13 - General Economics and Teaching - - General Economics - - - Relation of Economics to Social Values
    • B49 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Other
    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts

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