Optimal Contracts with Team Production and Hidden Information: An Experiment

Abstract

It is standard in agency theory to search for incentive-compatible mechanisms on the assumption that people care only about their own material wealth. Yet it may be useful to consider social forces in mechanism design and contract theory. We devise an experiment to explore optimal contracts in a hidden information context. A principal offers one of three possible contract menus to a team of two agents of unknown types. We observe numerous rejections of the more lopsided menus, and approach an equilibrium where one of the more equitable menus is proposed and agents accept a contract, selecting actions according to their types. The consensus menu differs across treatments that vary the payoffs resulting from a rejection. We find that an agent is more likely to reject a contract menu if her teammate rejected a contract menu in the previous period, suggesting that agents may be learning social norms; in addition, low-ability agents have a particularly adverse reaction to reduced wage offers.

Keywords: Experiment, Hidden Information, Optimal contract, Production Team, Wage Rigidity

JEL Classification: A13, B49, C91, C92, D21, J41