A Note on Efficiency Wage Theory and Principal-Agent Theory

Why are principal-agent models used in some circumstances and efficiency wage models in others? In this note, it is argued that efficiency wages provide incentives based on an evaluation of the agent's input, while the incentives analysed in principal-agent models rely on the agent's output. The choice between the two incentive schemes depends on the probability that the agent is caught shirking. Moreover, we demonstrate that a combination of input- and output-related elements provides stronger incentives than payment schemes based on merely one of these elements. However, the combination requires a more complex labour contract involving an increased cost of writing the contract. The interaction between this transaction cost and a hiring cost is analysed. Copyright Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research, 2006.