Can agent cheap talk mitigate agency problems in the presence of a noisy performance measure? an experimental test in a single-and multi-period setting

Jeremy Douthit, Linwood W. Kearney, Douglas E. Stevens

Research output: Contribution to journalArticle

7 Citations (Scopus)

Abstract

Given traditional agency theory assumptions and unobservable effort in a single-period setting, a moral hazard arises in which the agent is expected to shirk and provide the minimal possible effort after contracting with the principal. Traditional solutions to this agency problem include paying the agent a financial incentive tied to some noisy measure of performance or allowing the agent to develop a reputation over multiple periods. As the noisiness of the performance measure increases, however, these traditional solutions become increasingly costly and ineffective. In many single-and multi-period agency settings in the firm, however, the agent can communicate a promised level of effort to the principal prior to contracting. We document that this pre-contract communication, which is non-enforceable and therefore considered "cheap talk" by traditional economic theory, can be highly effective in mitigating the moral hazard problem in agency theory. In a repeating single-period experimental setting where production is observable but is a very noisy indicator of effort, communication of a promised level of effort results in higher pay for the agent, higher effort, and higher expected profit for the principal than the control group. When the principal and agent interact over multiple periods, reputation building is ineffective, but cheap talk continues to yield superior outcomes. These results are consistent with recent economic theory incorporating social norms such as the norm of promise-keeping.

Original languageEnglish (US)
Pages (from-to)135-158
Number of pages24
JournalJournal of Management Accounting Research
Volume24
Issue number1
DOIs
StatePublished - Dec 2012
Externally publishedYes

Fingerprint

Agency problems
Performance measures
Experimental tests
Cheap talk
Agency theory
Contracting
Economic theory
Moral hazard
Communication
Profit
Social norms
Financial incentives

Keywords

  • Agency problems
  • Agent cheap talk
  • Noisy performance measures
  • Promise-keeping
  • Social norms

ASJC Scopus subject areas

  • Accounting
  • Business and International Management

Cite this

Can agent cheap talk mitigate agency problems in the presence of a noisy performance measure? an experimental test in a single-and multi-period setting. / Douthit, Jeremy; Kearney, Linwood W.; Stevens, Douglas E.

In: Journal of Management Accounting Research, Vol. 24, No. 1, 12.2012, p. 135-158.

Research output: Contribution to journalArticle

@article{1aa8974851d7446bb5af684e519cb57a,
title = "Can agent cheap talk mitigate agency problems in the presence of a noisy performance measure? an experimental test in a single-and multi-period setting",
abstract = "Given traditional agency theory assumptions and unobservable effort in a single-period setting, a moral hazard arises in which the agent is expected to shirk and provide the minimal possible effort after contracting with the principal. Traditional solutions to this agency problem include paying the agent a financial incentive tied to some noisy measure of performance or allowing the agent to develop a reputation over multiple periods. As the noisiness of the performance measure increases, however, these traditional solutions become increasingly costly and ineffective. In many single-and multi-period agency settings in the firm, however, the agent can communicate a promised level of effort to the principal prior to contracting. We document that this pre-contract communication, which is non-enforceable and therefore considered {"}cheap talk{"} by traditional economic theory, can be highly effective in mitigating the moral hazard problem in agency theory. In a repeating single-period experimental setting where production is observable but is a very noisy indicator of effort, communication of a promised level of effort results in higher pay for the agent, higher effort, and higher expected profit for the principal than the control group. When the principal and agent interact over multiple periods, reputation building is ineffective, but cheap talk continues to yield superior outcomes. These results are consistent with recent economic theory incorporating social norms such as the norm of promise-keeping.",
keywords = "Agency problems, Agent cheap talk, Noisy performance measures, Promise-keeping, Social norms",
author = "Jeremy Douthit and Kearney, {Linwood W.} and Stevens, {Douglas E.}",
year = "2012",
month = "12",
doi = "10.2308/jmar-50199",
language = "English (US)",
volume = "24",
pages = "135--158",
journal = "Journal of Management Accounting Research",
issn = "1049-2127",
publisher = "American Accounting Association",
number = "1",

}

TY - JOUR

T1 - Can agent cheap talk mitigate agency problems in the presence of a noisy performance measure? an experimental test in a single-and multi-period setting

AU - Douthit, Jeremy

AU - Kearney, Linwood W.

AU - Stevens, Douglas E.

PY - 2012/12

Y1 - 2012/12

N2 - Given traditional agency theory assumptions and unobservable effort in a single-period setting, a moral hazard arises in which the agent is expected to shirk and provide the minimal possible effort after contracting with the principal. Traditional solutions to this agency problem include paying the agent a financial incentive tied to some noisy measure of performance or allowing the agent to develop a reputation over multiple periods. As the noisiness of the performance measure increases, however, these traditional solutions become increasingly costly and ineffective. In many single-and multi-period agency settings in the firm, however, the agent can communicate a promised level of effort to the principal prior to contracting. We document that this pre-contract communication, which is non-enforceable and therefore considered "cheap talk" by traditional economic theory, can be highly effective in mitigating the moral hazard problem in agency theory. In a repeating single-period experimental setting where production is observable but is a very noisy indicator of effort, communication of a promised level of effort results in higher pay for the agent, higher effort, and higher expected profit for the principal than the control group. When the principal and agent interact over multiple periods, reputation building is ineffective, but cheap talk continues to yield superior outcomes. These results are consistent with recent economic theory incorporating social norms such as the norm of promise-keeping.

AB - Given traditional agency theory assumptions and unobservable effort in a single-period setting, a moral hazard arises in which the agent is expected to shirk and provide the minimal possible effort after contracting with the principal. Traditional solutions to this agency problem include paying the agent a financial incentive tied to some noisy measure of performance or allowing the agent to develop a reputation over multiple periods. As the noisiness of the performance measure increases, however, these traditional solutions become increasingly costly and ineffective. In many single-and multi-period agency settings in the firm, however, the agent can communicate a promised level of effort to the principal prior to contracting. We document that this pre-contract communication, which is non-enforceable and therefore considered "cheap talk" by traditional economic theory, can be highly effective in mitigating the moral hazard problem in agency theory. In a repeating single-period experimental setting where production is observable but is a very noisy indicator of effort, communication of a promised level of effort results in higher pay for the agent, higher effort, and higher expected profit for the principal than the control group. When the principal and agent interact over multiple periods, reputation building is ineffective, but cheap talk continues to yield superior outcomes. These results are consistent with recent economic theory incorporating social norms such as the norm of promise-keeping.

KW - Agency problems

KW - Agent cheap talk

KW - Noisy performance measures

KW - Promise-keeping

KW - Social norms

UR - http://www.scopus.com/inward/record.url?scp=84870178722&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=84870178722&partnerID=8YFLogxK

U2 - 10.2308/jmar-50199

DO - 10.2308/jmar-50199

M3 - Article

AN - SCOPUS:84870178722

VL - 24

SP - 135

EP - 158

JO - Journal of Management Accounting Research

JF - Journal of Management Accounting Research

SN - 1049-2127

IS - 1

ER -