DP11002 Hidden Action and Outcome Contractibility: An Experimental Test of Contract Theory

Author(s): Eva I Hoppe, Patrick W. Schmitz
Publication Date: December 2015
Keyword(s): Contract theory, Hidden action, Incentive theory, Laboratory experiments, Moral hazard
JEL(s): C72, C92, D82, D86
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11002

We present the first large-scale laboratory experiment designed to capture the canonical hidden action problem as studied in contract theory, comparing treatments with unobservable effort to benchmark treatments with verifiable effort. In line with contract theory, when effort is a hidden action, the chosen effort levels crucially depend on the contractibility of the outcome. In our one-shot experiment the players endogenously negotiate contracts. In the absence of communication, they typically avoid gift-exchange situations. Even when the outcome is contractible and the hidden action problem is typically overcome with incentive-compatible contracts, communication is helpful since it may reduce strategic uncertainty.