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

Research output: Contribution to journalArticle

7 Scopus citations

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 1 2012

    Fingerprint

Keywords

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

ASJC Scopus subject areas

  • Business and International Management
  • Accounting

Cite this