Trust and Incentives in Principal-agent Negotiations: the “insurance/incentive Trade-off”

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 summarizes some 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. This is precisely the kind of efficient outcome that principalagency theory says is unavailable. 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. The connections to the literature on public bureaucracy are numerous. The focus on principal-agency theory and incentives has caused us to lose track of the research agenda that once defined public bureaucracy – such as bureaucratic "types”, cooperation in a hierarchy, and professionalism and its obligations.