Think Twice before Going for Incentives: Social Norms and the Principal’s Decision on Compensation Contracts

Abstract

Principals make decisions on various issues, ranging from contract design to control system implementation. Few studies examine the principal’s active role in these decisions. We experimentally investigate this role by studying how a principal’s choice for a truth-telling incentive contract, compared to a fixed-salary contract without truth-telling incentives, affects the honesty of their agents’ cost reporting. Results show that besides an incentive effect and a principal trust effect (Christ et al. [2012]), the active choice for incentives produces a negative “information leakage” effect. When principals use incentives, their choices not only incentivize truthful reporting and signal distrust, but they also leak important information about the social norm; namely, that other agents are likely to report dishonestly. Agents conform to this social norm by misrepresenting cost information more. Our results have important practical implications. Managers must recognize that their decisions can leak information to their agents, which may produce unanticipated consequences for the social norms of the organization.

Keywords: Incentive contract, information leakage effect, social norms, honesty

JEL Classification: C91, D83, M40