Principal-Agent Settings with Random Shocks

Rubin, Jared and Sheremeta, Roman (2015): Principal-Agent Settings with Random Shocks. Forthcoming in: Management Science

Abstract

Using a gift exchange experiment, we show that the ability of reciprocity to overcome incentive problems inherent in principal-agent settings is greatly reduced when the agent’s effort is distorted by random shocks and transmitted imperfectly to the principal. Specifically, we find that gift exchange contracts without shocks encourage effort and wages well above standard predictions. However, the introduction of random shocks reduces wages and effort, regardless of whether the shocks can be observed by the principal. Moreover, the introduction of shocks significantly reduces the probability of fulfilling the contract by the agent, the payoff of the principal, and total welfare. Therefore, our findings demonstrate that random shocks place an important bound on the ability of gift exchange to overcome principal-agent problems.

• Item Type: MPRA Paper
• Language: English
• Keywords: gift exchange, principal-agent model, contract theory, reciprocity, effort, shocks, laboratory experiment
• Subjects: C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C72 - Noncooperative Games; C - Mathematical and Quantitative Methods > C9 - Design of Experiments > C91 - Laboratory, Individual Behavior; D - Microeconomics > D6 - Welfare Economics > D63 - Equity, Justice, Inequality, and Other Normative Criteria and Measurement; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; H - Public Economics > H5 - National Government Expenditures and Related Policies > H50 - General

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