Think Twice before Going for Incentives: Social Norms and the Principal’s Decision on Compensation Contracts

Principals make decisions on various issues, ranging from compensation contract design, delegation decisions, to control system implementation. Most studies, however, ignore the principal’s active role in these decisions. We experimentally investigate this active role by studying the consequences of the principal’s choice for a truth-telling incentive contract on agents’ honest reporting. We find that the principal’s choice for incentives produces both an incentive effect and a negative ‘signaling’ effect compared to a contract witho ut truth-telling incentives (fixed salary). While the principal’s choice for incentives motivates people to report more truthfully, this choice also signals information about the social norm to the agent, indicating that other agents are likely to report dishonestly. Agents conform to this social norm by misrepresenting cost information more. We further find that the signaling effect is stronger for participants who are more receptive to norms. Moreover, the negative signaling effect materializes after controlling for intentionality effect and only materializes when principals can act on the observation of other agents’ behavior. Our results have important implications for practice. Managers should be aware that their decisions on incentives can leak information to their agents. Such information leakage can have important unanticipated consequences for the social norms that may arise in the organization.

This seminar is organised by the Erasmus Accounting Research Group.