Comparing Incentive Contract Desirability within an Integrated Risk Setting

Abstract

In this study, we experimentally investigate how performance risk and relational risk affect a principal’s willingness to offer gift, bonus, or penalty contracts and the subsequent motivational effect that these three contracts have on agents. Prior literature has not directly compared performance-contingent contracts to gift contracts, and extrapolation from existing empirical data is difficult because the literature has typically examined each in settings focused only on the mechanism through which each contract acts (i.e., interactive settings for gift exchange and settings with stochastic production and unobservable effort for performance-contingent contracts). We combine features of both settings and construct a willingness-to-pay (WTP) measure indicative of the principal’s propensity to offer a contract. Comparing the WTPs for the contracts, we find that gift exchange contracts are less attractive to principals than performance-contingent contracts. More importantly, we demonstrate that performance-contingent contracts evoke reciprocity concerns, suggesting that they function as both incentive compatible instruments, consistent with agency theory, and as behavioral instruments, consistent with models of gift exchange.