Institute for Empirical Research in Economics

University of Zurich
Working Paper Series
ISSN 1424-0459

forthcoming in: Experimental Economics

Working Paper No. 18

Efficient Contracting and Fair Play in a Simple

Principal-Agent Experiment
Vital Anderhub, Simon Gchter and Manfred Knigstein
September 2000

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Figures

Figure 1: Marginal return function and marginal cost function as well as

conditionally rational eort choices for s = 60%, respectively s = 100%.

28

Figure 2a: Distribution of oered xed wages

Figure 2b: Distribution of oered return shares

Figure 2c: Distribution of suggested eort

29

Figure 3: Combinations of return share and xed wage

as oered by the principals

Figure 4: Surplus share oered to the agent

(for e cient contract oers)
30

Figure 5: Predicted acceptance rate (probability of = 1) conditional

on the surplus share oered to the agent according
to logit regressions for RG1, respectively RG2

Figure 6: Frequency distribution of agents actual eort choices

in both sequences of the repeated games (RG1 and RG2)
31

Figure 7: Conditionally rational eort choices

32

Figure 8: The number of individuals who deviated from rational

eort (e eb) for a given surplus share is indicated above the respective bar

33

Appendix: Experimental instructions

These instructions were originally written in German. Both the principal and the agent received
- except for some role-specific minor details - the same instructions.

General information
The experiment you participate today is joint research with the Humboldt-University Berlin. It is financed by several
science foundations. For your participation you will receive 15 Swiss Francs. Dependent on your decisions you can
earn additional money. It is possible that some of your decisions lead to losses. You will have to finance them out of
the gains from your other decisions, or, if necessary out of your show-up fee. However, you can always make
decisions that avoid any losses.
During the experiment you income will be calculated in points. The exchange rate of points into Swiss Francs is
1 point = 1.3 Rappen.
At the end of the experiment all points you have earned will be summed up, exchanged into Swiss Francs and paid
out to you in cash immediately.
Please note that during the experiment communication is not allowed. If you do have questions please raise
you hand. We will answer you questions in private.

Instructions
1. Introduction
In this experiment you will learn about a decision problem that involves two persons. We will call them participants
X and Y. All participants in this experiment are allocated in two groups: the group of participants X and the
group of participants Y.
You belong to the group of participants X!
Thus, you will decide during the whole experiment in the role of a participant X.
The experiment consists of 6 periods. At the beginning you will be randomly matched with a participant of group Y.
You will be paired with this participant in all 6 periods. You will make your decisions at the computer. The usage of
the computer will be explained to you if necessary. Your decisions will be transmitted via the computer to participant
Y. This participant will only get informed about your decision. He will never learn your name or your participant
number, i.e., your decisions remain anonymous.

2. An overview of the experiment

The experiment consists of 6 periods. It may help you to understand the decision situation if you think about the
following scenario. Participant X decides in the role of a "firm". The "firm" has an employee (participant Y), whose
work effort produces some period return. Y can choose his work effort freely in each period. Below we will explain
what work effort means and how the period return comes about. However, it is true that a higher work effort leads to
a higher period return, but it also causes costs that Y has to bear.
Y's payment is determined in an employment contract and can take place in two forms, with a fixed wage and/or a
return share. The fixed wage has to be paid by participant X to participant Y independently of the period return. A

return share means that Y receives an agreed share (in percent) of the return. In the following we will call these
percentage share "return share Y". In consequence, the "return share X" is just the rest (i.e., 100 percent minus
"return share Y").
Thus, each period consists of three stages:
1. X makes, in accordance with the rules, up to two contract proposals.
2. Y chooses one contract among the possible contracts.
3. Y makes his work effort choice.
Afterwards X and Y will be paid according to the rules.

3.

The experimental details

3.1 Employment contract: The proposals of participant X

At the beginning of each period, first an employment contract will be determined. For the contract design the
following holds:
In each period there is a so-called "status quo"-contract that becomes effective if there is no agreement about a
new contract. The "status quo"-contract consists of a fixed payment of 0 and a "return share Y" of 0. This "status
quo"-contract is the same in each period.
In addition to the "status quo"-contract in each period X can
- in the first period make up to two new contract proposals
- in each of the later periods make one new contract proposal.
Y decides whether he accepts the new contract proposal (or which of the new proposals he accepts, respectively), or
whether the "status quo"-contract shall become valid.
Each contract proposal by X also contains a desired work effort that, however, is not binding for Y.
A contract proposal consists of three components: a fixed wage, a "return share Y" and a desired work effort.
Participant X is in the bounds of the rules given below completely free in the design of the contract proposals.
It is possible to agree on a positive or a negative fixed wage. If the fixed wage is positive, this means that
participant Y gets this wage from participant X, regardless of the period return. A negative fixed wage means that
Y has to pay that amount to X, regardless of the period return.
The "return share Y" is expressed in percentage points. It says how large Y's share - in percent - of the total
period return is. Participant X gets the rest ("return share X" = 100 percent minus "return share Y").
X's desired work effort is not binding for Y.
For the contract design the following rules hold:
700 fixed wage 700
0 "return share Y" 100 (in percent)
0 desired work effort 20
Only integer numbers are possible!
In designing the contracts ALL combinations that are compatible with these rules are possible!

To make the rules clear to you, we depict the screen that will be shown to X at the beginning of period 1:

On this screen (as well as in all other screens in which you have to make a decision) you see the current period
number at the top left and at the top right the remaining time. Participant X now has the possibility to make up to two
contract proposals by just entering them into the corresponding boxes. The screen for the subsequent periods is very
similar except that participant X can only propose one new contract.
3.2 Employment contract: The choice by participant Y
Participant Y chooses among the available contracts. In period 1 Y can choose between the "status quo"-contract
(fixed wage of 0 ["Festgehalt"], return share Y ["Erlsanteil von Y"] of 0 %) and contract 1 or contract 2, and in
all other periods between the "status quo"-contract or a new contract.
3.3 Work effort of participant Y
After Y has chosen a contract, he determines his work effort. The desired work effort ["gewnschter
Arbeitseinsatz"] stated by participant X in the contract is not binding for participant Y. The work effort is expressed
as a number. In the enclosed table all possible work efforts (all integer numbers between 0 and 20) as well as the
produced returns are given. The table also contains the costs of the work effort that Y has to bear. The higher the
work effort, the higher is the return but the higher are also the costs of the work effort.
3.4 Period payoffs and end of period
After participant Y has entered his work effort into the computer, the period gains will be calculated according to the
formulas stated on the enclosed table.

Afterwards both participants will be informed about the decisions (work effort, fixed wages, "return share Y"), own
period payoff and the sum of the own payoffs so far. This ends a period and the next one starts.

4. Control questionnaire
The following control questions are only designed to test your understanding of the payoff calculations. You should
learn - with the help of some arbitrary examples - how the payoffs of X and Y change if the terms of the contract, or
the work effort changes. In the experiments you are in no way bound by these examples!

1. Y accepts the following contract: fixed wage: 580, return share Y: 10 %. Calculate the payoffs of X and Y if Y
chooses a work effort of 2.
Payoff X:
Payoff Y:
2. The same as 1., but Y chooses a work effort of 18.
Payoff X:
Payoff Y:
3. Y accepts the following contract: fixed wage: 580, return share Y: 90 %. Calculate the payoffs of X and Y if Y
chooses a work effort of 2.
Payoff X:
Payoff Y:
4. The same as 3., but Y chooses a work effort of 18.
Payoff X:
Payoff Y:
5. Y accepts the following contract: fixed wage: -580, return share Y: 10 %. Calculate the payoffs of X and Y if Y
chooses a work effort of 2.
Payoff X:
Payoff Y:
6. The same as 5., but Y chooses a work effort of 18.
Payoff X:
Payoff Y:
7. Y accepts the following contract: fixed wage: -580, return share Y: 90 %. Calculate the payoffs of X and Y if Y
chooses a work effort of 2.
Payoff X:
Payoff Y:
8. The same as 7., but Y chooses a work effort of 18.
Payoff X:
Payoff Y:
9. Y accepts the following contract: fixed wage: 120, return share Y: 0 %. Calculate the payoffs of X and Y if Y
chooses a work effort of 0.
Payoff X:
Payoff Y:
10. Y accepts the following contract: fixed wage: -120, return share Y: 100 %. Calculate the payoffs of X and Y if Y
chooses a work effort of 20.
Payoff X:
Payoff Y:
11. Y accepts the "status quo"-contract: fixed wage: 120, return share Y: 0 %. Calculate the payoffs if Y chooses a
work effort of 0.
Payoff X:
Payoff Y:

Work effort, return of the work effort and costs of the work effort for Y:
Total period return from work
Work effort:

costs of work effort for Y

effort

35

70

10

105

15

140

20

175

30

210

40

245

50

280

60

315

75

10

350

90

11

385

105

12

420

120

13

455

140

14

490

160

15

525

180

16

560

200

17

595

225

18

630

250

19

665

275

20

700

300

Period payoff Y:

return share Y [= "return share Y"/100 return]

+ fixed wage
costs of work effort

Period payoff X:

return share X [=((100 "return share Y")/100) . return]

fixed wage

Please note: the return share is given in percentages and shares the period return between X and Y.