51 Pages Posted: 11 Aug 2013
Date Written: June 2013
The paper explores the "hidden costs of rewards" in a dynamic principal-agent framework, in which an informed principal selects in each period a reward for an agent. It shows that rewards are often addictive in that once offered, a contingent reward makes the agent expect it whenever a similar task is faced. This expectation develops because rewards bring bad news: a higher reward is more likely to be offered when the task is difficult or the agent is weak. This, in turn, compels the principal to use rewards over and over again. Furthermore, in a long-term principal-agent relationship there is a two-sided ratchet effect: the principal is concerned about creating addiction for the agent, whereas the agent does not want to appear too enthusiastic. On the principal's side, the ratchet effect implies that there are fewer rewards in a long-term principal-agent relationship than in a situation where the agent faces transient principals while implementing a series of similar tasks. On the agent's side, ratcheting conflicts with a desire to work in order to acquire valuable information about the task attractiveness. If doing the task once allows the agent to fully learn its characteristics, addiction may not develop. In contrast, the principal may first promise a bonus when the task is easy, rather than difficult (or the agent is strong) so as to induce the agent to acquire the good news "by doing". Then, bonuses become redundant thereafter.
Keywords: addiction, rewards, ratchet effect, self-con fidence, informed principal
JEL Classification: A12, D82, J22, J33
Suggested Citation: Suggested Citation