Optimal Contracts, Adverse Selection, and Social Preferences: An Experiment

Abstract

It has long been standard in agency theory to search for incentive compatible mechanisms on the assumption that people care only about their own material wealth. However, this assumption is clearly refuted by numerous experiments, and we feel that it may be useful to consider nonpecuniary utility in mechanism design and contract theory. Accordingly, we devise an experiment to explore optimal contracts in an adverse-selection context. A principal proposes one of three contract menus, each of which offers a choice of two incentive-compatible contracts, to two agents whose types are unknown to the principal. The agents know the set of possible menus, and choose to either accept one of the two contracts offered in the proposed menu or to reject the menu altogether; a rejection by either agent leads to lower (and equal) reservation payoffs for all parties. While all three possible menus favor the principal, they do so to varying degrees. We observe numerous rejections of the more lopsided menus, and approach an equilibrium where one of the more equitable contract menus (which one depends on the reservation payoffs) is proposed and agents accept a contract, selecting actions according to their types. Behavior is largely consistent with all recent models of social preferences, strongly suggesting there is value in considering nonpecuniary utility in agency theory.

The classic ‘lemons’ paper (Akerlof 1970) illustrated the point that asymmetric information led to economic inefficiency, and could even destroy an efficient market. Research on mechanism design has sought ways to minimize or eliminate this problem. Seminal research includes the auction results of Vickrey (1961) and the optimal taxation study by Mirrlees (1971). Applications include public and regulatory economics (Laffont and Tirole 1993), labor economics (Weiss 1991, Lazear 1997), financial economics (Freixas and Rochet 1997), business management (Milgrom and Roberts 1992), and development economics (Ray 1998).

It has long been standard in agency theory to search for incentive-compatible mechanisms on the assumption that people care only about their own material wealth. However, while this assumption is a useful point of departure for a theoretical examination, economic interactions frequently are associated with social approval or disapproval. In dozens of experiments, many people appear to be motivated by some form of social preferences, such as altruism, difference aversion, or reciprocity. Recently, contract theorists such as Casadesus-Masanell (1999) and Rob and Zemsky (1999) have expressed the view that contract theory could be made more descriptive and effective by incorporating some form of nonpecuniary utility into the analysis.

We consider the explanatory power of recent social preference models (e.g., Bolton and Ockenfels 2000, Fehr and Schmidt 1999, and Charness and Rabin 1999) in our contractual environment. Our aim is to investigate whether incorporating social preferences into contract theory could lead to a better understanding of how work motivation and performance are linked, and to thereby improve firms’ contract and employment choices, as well as productivity and efficiency.

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