The Monotonicity Puzzle: An Experimental Investigation of Incentive Structures

Abstract

Non-monotone incentive structures, which — according to theory — are able to induce optimal behavior, are often regarded as empirically less relevant for labor relationships. We compare the performance of a theoretically optimal non-monotone contract with a monotone one under controlled laboratory conditions. Implementing some features relevant to real-world employment relationships, our paper demonstrates that, in fact, the frequency of income-maximizing decisions made by agents is higher under the monotone contract. Although this observed behavior does not change the superiority of the non-monotone contract for principals, they do not choose this contract type in a significant way. This is what we call the monotonicity puzzle. Detailed investigations of decisions provide a clue for solving the puzzle and a possible explanation for the popularity of monotone contracts.

Organization and Incentivization of Risk Management

“…Under more general model, also a riskneutral agent could be incentivized to provide a variance-reducing effort, i. e. through implementation of a non-monotone contract. The experimental results suggest that such contracts may be accepted by the agents and lead to optimal results (Brosig et al 2010). Nonetheless, this contracting form is not typically found in the managerial contracts in practice; usually, output-based pay is used, as "in uncertain environments, there are no other good measures by which to align incentives" (Prendergast 2002(Prendergast , p. 1073.…”

Monotonicity of Optimal Contracts Without the First-Order Approach

“…Typically, quite strong additional analytical assumptions (discussed below) are needed. The fact that the "monotonicity" of the relationship between actions and outcomes via the MLRP does not directly translate to monotonicity of the optimal contract is one of the great "puzzles" of agency theory (Brosig et al 2010).…”

Contract design in dynamic agency: An experimental analysis

“…Finally, it may be difficult for participants to actually determine the theoretically optimal contract. Although this may be easier with exogenously given (fixed) contracts (e.g., Berg et al, 1992;Brosig, Lukas, & Riechmann, 2010;Lukas, 2007a;Nieken & Schmitz, 2012), the task becomes challenging if participants can freely determine contract parameters (e.g., Fehr et al, 2007;Keser & Willinger, 2000, 2007.…”

“…For example, Chaudhuri (1998) and Charness, Kuhn, and Villeval (2010) investigate the ratchet effect in a dynamic agency model with hidden characteristics. Because I study a model with hidden action, my paper is related to Lukas (2007a), Brosig et al (2010), Cochard and Willinger (2005), Nieken andSchmitz (2012), andLukas (2016). Lukas (2007a), Brosig et al (2010), and Lukas (2016) study a setup similar to mine, but in their experiments, principals choose between two exogenously given contracts.…”

“…Because I study a model with hidden action, my paper is related to Lukas (2007a), Brosig et al (2010), Cochard and Willinger (2005), Nieken andSchmitz (2012), andLukas (2016). Lukas (2007a), Brosig et al (2010), and Lukas (2016) study a setup similar to mine, but in their experiments, principals choose between two exogenously given contracts. In contrast to these studies, Cochard and Willinger (2005), Huck, Seltzer, andWallace (2011), andNieken andSchmitz (2012) analyze settings in which the principal has substantial leeway in determining contract parameters.…”