Contract Choice: Efficiency and Fairness in Revenue‐Sharing Contracts

Published date01 October 2017
DOIhttp://doi.org/10.1111/sjoe.12200
Date01 October 2017
Contract Choice: Efficiency and Fairness
in Revenue-Sharing Contracts
Alexandros Karakostas
University of Erlangen-Nuremberg, DE-90403 Nuremberg, Germany
karakostas.alex@gmail.com
Axel Sonntag
University of Vienna, A-1090 Vienna, Austria
axel.sonntag@univie.ac.at
Daniel John Zizzo
Newcastle University, Newcastle upon Tyne NE1 7RU, UK
daniel.zizzo@ncl.ac.uk
Abstract
We present a simple principal–agent experiment in which the principals are allowed to choose
between a revenue-sharing, a bonus, and a trust contract, to offer to an agent. Our findings
suggest that a large majority of experimental subjects choose the revenue-sharing contract.
This choice turns out to be not only the most efficient but also, at the same time, fair. Overall,
the distribution of earnings is only mildly skewed towards the principal. We conclude that,
under revenue-sharing contracts, concerns for fairness can be closely associated with the use
of monetary incentives.
Keywords: Bonus contract; incentive contract; lab experiment; moral hazard; trust
JEL classification:C91; J41; M52
I. Introduction
In this paper, we use an experiment to compare how principals choose
among three different contract types: revenue-sharing contracts, bonus con-
tracts, and trust contracts. Contract choice is clearly important from the
perspective of the efficiency of any transactions that involve principals and
agents; yet, to our knowledge, only a limited number of experimental stud-
ies directly compare different types of contracts, and none has looked at
We thank Enrique Fatas, David Masclet, Anders Poulsen, Klaus Schmidt, two anonymous
reviewers, and participants of presentations in Cologne and Norwich for advice. The ex-
perimental instructions and other appendices are available online. The experiment was pro-
grammed using Z-TREE (Fischbacher, 2007) and the experimental dataset is available from
the first author.
Also affiliated with the Behavioural and Experimental Northeast Cluster (BENC).
©The editors of The Scandinavian Journal of Economics 2016.
Scand. J. of Economics 119(4), 962–986, 2017
DOI: 10.1111/sjoe.12200
the combinations of contracts we consider. We find that revenue-sharing
contracts are a particularly useful contract to consider as part of the menu
of choices offered to the principal. Revenue-sharing contracts are used
extensively in sharecropping (Allen and Lueck, 1992), the video rental in-
dustry (Dana and Spier, 2001), gate revenue sharing in sports (Szymanski
and Kesenne, 2004), law, accounting, and architecture firms (Greenwood
and Empson, 2003), among other professions. These are evidently contracts
of potentially general interest.
In a trust contract, the principal pays a fixed wage to the agent and
requests an effort level. As the fixed wage is paid before the agent decides
on an effort level, the agent has no incentive for exerting the requested
effort. In the bonus contract, in addition to the fixed wage and requested
effort, the principal announces a voluntary bonus that she is willing to
pay if the exerted effort is equal to or exceeds the requested effort. As
this announcement is not binding, there is still no incentive to exert effort.
However, Fehr et al. (2007) find that when offered the choice between
an enforceable monitoring contract and a non-enforceable bonus contract,
most principals (roughly 90 percent) preferred the bonus contract. Addi-
tionally, the effort exerted by the agents and the average payoff for both the
principals and the agents were higher in bonus contract than in monitoring
contract settings (Fehr et al., 2007). The interpretation by Fehr et al. (2007)
of their findings is that the bonus contract was preferred to the monitoring
contract because of fairness concerns. However, it is possible that a con-
tract that contained the opportunity of fining could have been perceived
as a hostile act itself, and that it might send the agent a signal of dis-
trust (see Frey, 1998; Fehr and Rockenbach, 2003; Dickinson and Villeval,
2008).1This, in turn, could have increased the likelihood of shirking,
by generating a self-fulfilling prophecy of distrust (see Bacharach et al.,
2007). In contrast, in an experiment employing revenue-sharing contracts,
where a principal defines a fixed wage and additionally offers the agent a
share of the total (gross) revenue, Anderhub et al. (2002, p. 24) found that
principals “clearly recognize the agency problem and react accordingly” by
developing incentive-compatible and profit-maximizing contracts. However,
a significant proportion of the principals also take concerns of fair ness into
account, in the sense of providing larger than the predicted shares of the
total revenue to the agents. In principle, a contract that ex ante reduces the
risk for the principal could be quite attractive to a risk-averse principal, and
1More generally, the contract choice can provide important information to the employee
regarding the employer (e.g., Falkand Kosfeld, 2006) or even the behavior of other employees
(Danilov and Sliwka, 2013), which in turn can have either positive or negative effects on the
intrinsic motives of agents. Bowles and Polania-Reyes (2012) provide a systematic review of
what they identify as the four crowding-out mechanisms of intrinsic incentives.
A. Karakostas, A. Sonntag, and D. J. Zizzo 963
©The editors of The Scandinavian Journal of Economics 2016.

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