Contracts, Fairness, and Incentives

51 Pages Posted: 24 May 2004

See all articles by Ernst Fehr

Ernst Fehr

University of Zurich - Department of Economics

Alexander Klein

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics

Klaus M. Schmidt

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Date Written: June 2004

Abstract

We show experimentally that fairness concerns may have a decisive impact on both the actual and the optimal choice of contracts in a moral hazard context. Explicit incentive contracts that are optimal according to self-interest theory become inferior when some agents value fairness. Conversely, implicit bonus contracts that are doomed to fail among purely selfish actors provide powerful incentives and become superior when there are some fair-minded players. The principals understand this and predominantly choose the bonus contracts, even preferring a pure bonus contract over a contract that combines the enforcement power of explicit and implicit incentives. This contract preference is associated with the fact that explicit incentives weaken the enforcement power of implicit bonus incentives significantly. Our results are largely consistent with recently developed theories of fairness, which also offer interesting new insights into the interaction of contract choices, fairness and incentives.

Keywords: Moral hazard, incentives, bonus contract, fairness, inequity aversion

JEL Classification: C7, C9, J3

Suggested Citation

Fehr, Ernst and Klein, Alexander and Schmidt, Klaus M., Contracts, Fairness, and Incentives (June 2004). CESifo Working Paper Series No. 1215, Available at SSRN: https://ssrn.com/abstract=549224

Ernst Fehr

University of Zurich - Department of Economics ( email )

Bl├╝mlisalpstrasse 10
Zuerich, 8006
Switzerland
+41 1 634 3709 (Phone)
+41 1 634 4907 (Fax)

Alexander Klein

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics ( email )

Ludwigstrasse 28
Munich, D-80539
Germany
+49 89 2180 3907 (Phone)
+49 89 2180 3510 (Fax)

Klaus M. Schmidt (Contact Author)

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics ( email )

Ludwigstrasse 28
Munich, D-80539
Germany
+49 89 2180 3405 (Phone)
+49 89 2180 3510 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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