Use and Abuse of Authority

Björn Bartling, Ernst Fehr and Klaus M. Schmidt

Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems from Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich

Abstract: Employment contracts give a principal the authority to decide flexibly which task his agent should execute. However, there is a tradeoff, first pointed out by Simon (1951), between flexibility and employer moral hazard. An employment contract allows the principal to adjust the task quickly to the realization of the state of the world, but he may also abuse this flexibility to exploit the agent. We capture this tradeoff in an experimental design and show that principals exhibit a strong preference for the employment contract. However, selfish principals exploit agents in one-shot interactions, inducing them to resist entering into employment contracts. This resistance to employment contracts vanishes if fairness preferences in combination with reputation opportunities keep principals from abusing their power, leading to the widespread, endogenous formation of efficient long-run employment relations. Our results inform the theory of the firm by showing how behavioral forces shape an important transaction cost of integration – the abuse of authority – and by providing an empirical basis for assessing differences between the Marxian and the Coasian view of the firm, as well as Alchian and Demsetz’s (1972) critique of the Coasian approach.

Keywords: theory of the firm; transaction cost economics; authority; power abuse; employment relation; fairness; reputation (search for similar items in EconPapers)
JEL-codes: C91 D23 D86 M5 (search for similar items in EconPapers)
Date: 2012-12
New Economics Papers: this item is included in nep-cbe, nep-cdm, nep-cta, nep-hpe and nep-hrm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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Working Paper: Use and Abuse of Authority (2012)
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