Trust and Incentives in Principal-Agent Negotiations: The 'Insurance/Incentive Trade-Off'

Journal of Theoretical Politics, Vol. 14, No. 2, pp. 231-267, 2002

Posted: 4 Jun 2005

See all articles by Andrew B. Whitford

Andrew B. Whitford

University of Georgia - Department of Public Administration and Policy

Abstract

The canonical principal-agent problem involves a risk-neutral principal who must use incentives to motivate a risk-averse agent to take a costly, unobservable action that improves the principal's payoff. The standard solution requires an inefficient shifting of risk to the agent. This paper, however, summarizes experimental research that throws doubt on the validity of this conclusion. Experimental subjects were routinely able to achieve efficiency in agent effort levels without inefficient risk-sharing. These experimental outcomes, while anomalous from the standpoint of principal-agency theory, are quite consistent with other experimental data testing notions of trust-based implicit contracting. Such contracting within a hierarchy may allow an outcome preferred, by both principal and agent, to that deemed possible by principal-agency theory. If this is true, then the lessons to be learned from principal-agency theory are all the wrong ones. Concentrating on incentives can crowd out the very qualities in a relationship that make social efficiency possible.

Keywords: contracts, agency, trust, incentives, risk

JEL Classification: C92, D23, D73, L22

Suggested Citation

Whitford, Andrew B., Trust and Incentives in Principal-Agent Negotiations: The 'Insurance/Incentive Trade-Off'. Journal of Theoretical Politics, Vol. 14, No. 2, pp. 231-267, 2002, Available at SSRN: https://ssrn.com/abstract=734483

Andrew B. Whitford (Contact Author)

University of Georgia - Department of Public Administration and Policy ( email )

Athens, GA 30602
United States
706-542-2898 (Phone)
706-583-0610 (Fax)

HOME PAGE: http://andrewwhitford.com

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