An experimental investigation of the ‘tenuous trade-off’ between risk and incentives in organizations

Abstract

We investigate experimentally the relationship between risk and incentives in a principal–agent setting. In contrast to the existing empirical literature that describes such relationship as ‘tenuous’ or inconclusive, we find a clear negative relationship—supporting the prediction of the standard theoretical model. Specifically, we find that principals reduce the size of the offered piece rates with an increase in risk and instead provide positive fixed wages. Furthermore, we find no relationship between the variance in the performance and the effort choice of the agent, and a strong positive relationship between the effort choice of the agents and the offered piece rates as well as fixed wage, suggesting positive reciprocity. Finally, we find evidence of social projection by the principals regarding the agents’ degree of risk aversion.