Principal-Agent Settings with Random Shocks
Chapman University - The George L. Argyros School of Business & Economics
Roman M. Sheremeta
Case Western Reserve University; Case Western Reserve University
November 19, 2012
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.
Number of Pages in PDF File: 46
Keywords: gift exchange, principal-agent model, contract theory, reciprocity, effort, shocks, laboratory experiment
JEL Classification: C72, C91, D63, D81, J41
Date posted: September 27, 2012 ; Last revised: November 20, 2012
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