Abstract
We investigate experimentally the relationship between risk and incentives in a principal–agent setting. In contrast to the existing empirical literature that describes such relationship as ‘tenuous’ or inconclusive, we find a clear negative relationship—supporting the prediction of the standard theoretical model. Specifically, we find that principals reduce the size of the offered piece rates with an increase in risk and instead provide positive fixed wages. Furthermore, we find no relationship between the variance in the performance and the effort choice of the agent, and a strong positive relationship between the effort choice of the agents and the offered piece rates as well as fixed wage, suggesting positive reciprocity. Finally, we find evidence of social projection by the principals regarding the agents’ degree of risk aversion.
Highlights
One of the most celebrated results in personnel and organizational economics is on the optimal incentive intensity of employment contracts (Holmstrom and Milgrom 1987)
We present a controlled laboratory experiment that tests the relationship between incentive intensity and risk while isolating any alternative explanations
We investigate the relationship between risk and incentives through a principal–agent experiment
Summary
One of the most celebrated results in personnel and organizational economics is on the optimal incentive intensity of employment contracts (Holmstrom and Milgrom 1987). Sloof and van Praag (2008) test this experimentally and compare their results with expectancy theory, a theory developed by psychologists that predicts a negative relationship between effort and noise in the performance measure. In contrast to the current study that focuses on the optimal choice of incentive intensity, Sloof and van Praag (2008) focus on the optimal effort choice in a real-effort (number adding) task with noise Due to their divergent aim and to reduce complexity, they abstract away from the role of a principal and the subjects had to allocate effort between two different tasks. Their findings are in line with the linear agency model, as their results suggest that effort levels are invariant to the distribution of noise terms. The instructions as well as proofs of the theoretical predictions are provided in the “Appendix”
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