The Hidden Advantage of Delegation: Pareto-improvements in a Gift-exchange Game

2358 Many employment relationships are characterized by incomplete labor contracts in which the worker’s performance is not always enforceable. The firm’s profits depend (in part) on workers’ behavior. Thus, some combination of control and incentive devices is needed to get the best performance. The standard approach is to control the self-interested worker to the greatest extent possible, in order to avoid shirking and behavior not in the best interest of the firm, and to provide direct financial incentives to motivate this worker to be productive. According to standard economic theory, employees’ effort collapses to the minimum in either one-shot games or in repeated interactions with a finite time horizon. Thus, the employer has no incentive to pay an above-minimum wage. Nevertheless, a positive relationship between wage and effort has been found in a large number of gift exchange experiments and people have been shown to have a variety of nonpecuniary motivations. Furthermore, in an illuminating paper, Falk and Kosfeld (2006) find that exerting control can be counterproductive for firm profits. It may well be possible to find alternative mechanisms to harness alternative motivations to achieve higher profitability and potentially even better social outcomes. In this vein, Semco, a Brazilian manufacturer company, has operated as a real-world laboratory in the last two decades. One of Semco’s policy innovations was to allow workers to set their own salaries and working hours. It seems that the Semco experiment has been a huge success. An investment of $100,000 made in Semco 20 years ago would be worth $5.4 million today. Semler (1989, 1993), CEO and majority