Reciprocity and the Effectiveness of Optimal Agency Contracts

Optimal agency contracts pay the lowest wage necessary to induce the effort necessary to maximize firm profit. Employees could view such contracts as violating the reciprocity norm because they offer a low wage in exchange for expected high effort. Consequently, the profit-maximizing effectiveness of optimal contracts could be impaired if employees punish firms offering the optimal contract by reducing their effort or rejecting the contracts in favor of more reciprocal contracts. We conduct three experiments using experimental labor markets to examine 1) how employees respond to being offered an optimal agency contract versus a theoretically suboptimal reciprocity-based contract when each contract is the only contract available in the market, 2) how employees respond to these two contracts in a market where firms choose which one to offer, 3) whether firms ’ contract offers depend on employees ’ reactions to those contracts, and 4) how employees and firms react to a contract that incorporates important features of both the theoretically optimal contract and the reciprocity-based contract. We find that the theoretically optimal contract is less effective than standard economic analysis predicts