An experimental study of a dynamic principal-agent relationship

The principal-agent problem is often illustrated by the relationship between owners and managers in modern corporations. Our experimental study considers the problem where the owner has to motivate the manager by an employment contract serving the owner'rsquo;s interest. The contract specifies a salary and a share of the firm'rsquo;s profit which depends on the manager'rsquo;s effort and stochastic market events. The owner can only infer the firm'rsquo;s profitability from the dividend payments. The owner may terminate or change the incentive contract in later periods. The experiment relies on a parameter specification for which risk neutral participants would cooperate efficiently, i.e. the owner should design a contract rendering full effort as optimal. However, we observe contracts for which full effort is not optimal and effort choices which are not optimal. We observe trust and reciprocity as important features of behavior which evolve over a multiperiod principal-agent relationship, but do not carry over to the next game with a new partner. © 1998 John Wiley & Sons, Ltd.