The Ratchet Principle in a Principal Agent Game with Unknown Costs: An Experimental Analysis

In this paper we consider an experimental two-period game characterized by incomplete information.The agent produces an output for the principal and can have either high or low costs of production. The principal ex ante knows only that each is equally likely. The principal's aim is to extract the maximum possible surplus from the agent. The principal sets an output quota at the beginning of each period and does not commit to a long-term scheme and uses any information that becomes available about the agent's true type in setting next period's quota in order to extract the informational rent. We find that the agents play the game in a naive way - very often revealing their true types through their choices even though such type revelation is not optimal. However frequently the principal does not exploit this information in extracting more of the informational rent from the agent.