Posted: 22 Jun 2011 Last revised: 21 Jun 2012
Date Written: April 18, 2012
Given traditional agency theory assumptions and unobservable effort in a single-period setting, a moral hazard arises in which the agent is expected to shirk and provide the miminal possible effort after contracting with the principal. Traditional solutions to this agency problem include paying the agent a financial incentive tied to some noisy measure of performance or allowing the agent to develop a reputation over multiple periods. As the noisiness of the performance measure increases, however, these traditional solutions become increasingly costly and ineffective. In many single- and multi-period agency settings in the firm, however, the agent can communicate a promised level of effort to the principal prior to contracting. We document that this pre-contract communication, which is non-enforceable and therefore considered “cheap talk” by traditional economic theory, can be highly effective in mitigating the moral hazard problem in agency theory. In a repeating single-period experimental setting where production is observable but is a very noisy indicator of effort, communication of a promised level of effort results in higher pay for the agent, higher effort, and higher expected profit for the principal than the control group. When the principal and agent interact over multiple periods, reputation building is ineffective but cheap talk continues to yield superior outcomes. These results are consistent with recent economic theory incorporating social norms such as the norm of promise-keeping.
Keywords: agency problems, agent cheap talk, noisy performance measures, social norms, promise-keeping
JEL Classification: D23, D63, D82, J31, M52
Suggested Citation: Suggested Citation
Douthit, Jeremy and Kearney, Linwood and Stevens, Douglas E., Can Agent Cheap Talk Mitigate Agency Problems in the Presence of a Noisy Performance Measure? An Experimental Test in a Single- and Multi-Period Setting (April 18, 2012). Journal of Management Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1868986 or http://dx.doi.org/10.2139/ssrn.1868986