Principal-Agent Settings with Random Shocks

46 Pages Posted: 27 Sep 2012 Last revised: 20 Nov 2012

Jared Rubin

Chapman University - The George L. Argyros School of Business & Economics

Roman M. Sheremeta

Case Western Reserve University

Date Written: November 19, 2012

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.

Keywords: gift exchange, principal-agent model, contract theory, reciprocity, effort, shocks, laboratory experiment

JEL Classification: C72, C91, D63, D81, J41

Suggested Citation

Rubin, Jared and Sheremeta, Roman M., Principal-Agent Settings with Random Shocks (November 19, 2012). Available at SSRN: https://ssrn.com/abstract=2152623 or http://dx.doi.org/10.2139/ssrn.2152623

Jared Rubin

Chapman University - The George L. Argyros School of Business & Economics ( email )

One University Drive
Orange, CA 92866
United States

HOME PAGE: http://www.jaredcrubin.com

Roman M. Sheremeta (Contact Author)

Case Western Reserve University ( email )

10900 Euclid Ave.
Cleveland, OH 44106
United States

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