DP4512 Distrust - The Hidden Cost of Control

Author(s): Armin Falk, Michael Kosfeld
Publication Date: August 2004
Keyword(s): control, distrust, incentives, incomplete contracts, motivation, principal-agent relationship, trust
JEL(s): C7
Programme Areas: Labour Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=4512

We show experimentally that a principal's distrust in the voluntary performance of an agent has a negative impact on the agent's motivation to perform well. Before the agent chooses his performance, the principal in our experiment decides whether he wants to restrict the agents' choice set by implementing a minimum performance level for the agent. Since both parties have conflicting interests, restriction is optimal for the principal whenever the latter expects the agent to behave opportunistically. We find that most principals in our experiment do not restrict the agent's choice set but trust that the agent will perform well voluntarily. Principals who trust induce, on average, a higher performance and hence earn higher payoffs than principals who control. The reason is that most agents lower their performance as a response to the signal of distrust created by the principal's decision to limit their choice set. Our results shed new light on dysfunctional effects of explicit incentives as well as the puzzling incompleteness of many economic contracts.