The Cost of Incentives under Disagreement

This paper identifies a new cost of pay-for-performance incentives when principal and agent may disagree on the optimal course of action. In particular, pay-for-performance gives the agent a reason to disobey the principal, and thus act against his principal’s interests, when the two of them disagree. In other words, high-powered incentives may decrease the agent’s ‘zone of acceptance’ (Simon 1947) when principal and agent disagree. As a consequence, disagreement forces a trade-off between motivation and authority. This effect has a number of implications. First, and most importantly, agents who are subject to authority will have low-powered incentive pay. Second, intrinsically motivated agents with strong views will be more likely to disobey and thus, in equilibrium, less likely to be subject to authority and more likely to be independent entrepreneurs. A surprising result is that an increase in intrinsic motivation may actually decrease all players’ expected utility. Finally, subjective performance pay will be optimal when (and only when) the principal tries to exert interpersonal authority, and not just second-best when the outcome is difficult to measure or contract. I also discuss some potential implications for the theory of the firm. Through this analysis, the paper identifies an important difference between differing priors and private benefits (or private information): with differing priors, pay-for-performance may create agency problems rather than solving them. JEL Codes: D81, J3, L22, M12, M52