Naughty or nice? Punishment and the interaction of formal and informal incentives in long-term contractual relationships

The paper develops a model of repeated interaction between a buyer and a seller, which is then tested via laboratory experiments. The model allows for both formal and informal incentives in the contractual relationship between the parties. Formal incentives are explicit, performance-conditioned obligations enforced by third parties, such as a binding bonus paid for meeting an objectively measurable criterion. Informal incentives are non-binding promises to reward good performance. Although they are not enforced by external institutions, parties engaged in long-term interactions have incentives to “keep their words” about these promises and such payments can provide motivation for desirable performance. The current literature posits that these two types of incentives can function either as complements, so that joint use leads to better outcomes than either alone, or as substitutes, so that the availability of formal incentives may actually undermine the effectiveness of informal incentives. This study uses laboratory experiments to provide a rigorous test of hypotheses about the interaction of these incentives. The observed results suggest that the complementarity effect occurs in certain situations, but that the substitution effect does not occur as predicted, possibly because people do not punish transgressions in the manner that the theoretical model assumes.