IZA DP No. 1203 Distrust – The Hidden Cost of Control Armin Falk Michael Kosfeld DISCUSSION PAPER SERIES DISCUSSION PAPER July 2004 Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor Distrust – The Hidden Cost of Control Armin Falk IZA Bonn, University of Bonn Michael Kosfeld University of Zurich Discussion Paper No. 1203 July 2004 IZA P.O. Box 7240 53072 Bonn Germany Phone: +49-228-3894-0 Fax: +49-228-3894-180 Email: [email protected] Any opinions expressed here are those of the author(s) and not those of the institute. Research disseminated by IZA may include views on policy, but the institute itself takes no institutional policy positions. The Institute for the Study of Labor (IZA) in Bonn is a local and virtual international research center and a place of communication between science, politics and business. IZA is an independent nonprofit company supported by Deutsche Post World Net. The center is associated with the University of Bonn and offers a stimulating research environment through its research networks, research support, and visitors and doctoral programs. IZA engages in (i) original and internationally competitive research in all fields of labor economics, (ii) development of policy concepts, and (iii) dissemination of research results and concepts to the interested public. IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character. A revised version may be available on the IZA website (www.iza.org) or directly from the author. IZA Discussion Paper No. 1203 July 2004 ABSTRACT ∗ Distrust – The Hidden Cost of Control We show experimentally that a principal’s distrust in the voluntary performance of an agent has a negative impact on the agent’s motivation to perform well. Before the agent chooses his performance, the principal in our experiment decides whether he wants to restrict the agents’ choice set by implementing a minimum performance level for the agent. Since both parties have conflicting interests, restriction is optimal for the principal whenever the latter expects the agent to behave opportunistically. We find that most principals in our experiment do not restrict the agent’s choice set but trust that the agent will perform well voluntarily. Principals who trust induce, on average, a higher performance and hence earn higher payoffs than principals who control. The reason is that most agents lower their performance as a response to the signal of distrust created by the principal’s decision to limit their choice set. Our results shed new light on dysfunctional effects of explicit incentives as well as the puzzling incompleteness of many economic contracts. JEL Classification: C7, C9, M5 Keywords: trust, distrust, motivation, incentives, control, incomplete contracts, fairness Corresponding author: Armin Falk IZA Bonn P.O. Box 7240 53072 Bonn Germany Email: [email protected] ∗ Financial support by the MacArthur Foundation (Network on the Evolution of Individual Preferences and Social Norms), the Ludwig Boltzmann Institute for the Analysis of Economic Growth, and the Swiss National Science Foundation (Project No 12-67751.02) is gratefully acknowledged. Principal-agent relations are typically characterized by a conflict of interest. Therefore, principals often use control and incentive devices to eliminate agents' most opportunistic actions. This paper analyzes how the agent perceives the principal's decision to control and how this a®ects the agent's behavior. We conducted an experiment in which a principal can decide either to trust or to control the agent, where controlling rules out the agent's most opportunistic actions. Our results show that the decision to control signi¯cantly reduces the agents' willingness to act in the principal's interest. Explicit incentives back¯re and performance is lower if the principal controls compared to if he trusts. We analyze the interaction of motivation and control in a simple and parsimonious set- up. In the game under study, an agent chooses a productive activity x which is costly to him but which increases the principal's payo®. The distinguishing feature of our experiment is the principal's decision. Before choosing x, the principal determines the agent's choice set. He can either leave the choice of x completely to the agent's discretion, in which case the lowest possible choice of x is zero. Alternatively, the principal can force the agent to choose at least a minimum level x > 0. The de¯nition of the agent's choice set can be interpreted as the degree of control implemented in the agent's work environment. For example, making it impossible for the agent to choose below x is the equivalent of implementing various control or monitoring devices which restrain the agent from his most opportunistic choices. Not restricting the choice set, on the other hand, represents the absence of such control mechanisms. Alternatively, the restriction of the choice set can also be interpreted as the outcome of a corresponding employment contract. For example, if x represents the amount of working hours, x captures a minimum presence requirement. Similarly, if x stands for the quality of a produced good or service, x is the minimum quality the agent has to deliver. Since x is costly to the agent, standard economic theory predicts that the agent will choose the lowest possible x, which is zero if the principal does not restrict the agent's choice set and x > 0 if he does. Since the principal's payo® is increasing in x, he will therefore always be better o® controlling the agent than not limiting the agent's choice set. However, if there are agents who are intrinsically motivated to perform in the principal's interest, controlling may actually decrease performance. A potential reason is that agents do not like to be restricted and perceive control as a negative signal of distrust. In addition, these agents might also assume that the principal has low expectations. Our main results, in fact, con¯rm the hypothesis that control has an adverse e®ect on agents' performance. We ¯nd that a majority of the agents in our experiment choose a lower x if the principal restricts rather than trusts them. We vary the level of x in di®erent treatments. While we ¯nd evidence for the hidden costs of control in all treatments, the net e®ect on pro¯ts turns out to be non-monotonic. For low levels of x, control generates signi¯cantly lower pro¯ts than trust; as x rises, however, control eventually breaks even. In a detailed analysis of agents' motives behind control aversion, we ¯nd that agents seem to believe that principals 1 who control expect to receive less than those who don't, and that agents' beliefs correlate positively with their behavior. When asked for their perception of control, most agents indicate that they perceive the decision to control as a signal of distrust and a limitation of their choice autonomy. Given the hidden costs of control, principals earn more if they trust their agents than if they control. Most of the principals in our experiment seem to understand the adverse e®ect of control. The majority decides not to restrict the agent's choice set but to trust that the agent will perform well voluntarily. Principals who control hold more pessimistic beliefs about the agent's performance than principals who trust. As agents' behavior roughly con¯rms both types of beliefs, our results nicely support the so-called \self-ful¯lling prophecy of distrust" (Niklas Luhmann, 1968).1 We conducted several control treatments both to test the robustness of our results as well as to isolate the precise impact of control on agents' motivation. In one of these treatments, the constraint x is given exogenously, i.e., the agent's choice set is identical to that in the main experiment when the principal decides to control. However, since it is not the principal who implements x, distrust and control are not at issue in this treatment. If the principal's controlling decision is behaviorally relevant to the agent, x should therefore be lower if the principal decides to control in the main treatment than in the control treatment. This is what we ¯nd. In a further treatment, we embed the principal's control decision in a standard gift-exchange game. A principal in this treatment not only decides whether to control his agent but also determines his agent's wage. In line with previous studies, we ¯nd that agents' x-choices are generally increasing in the wage payment, i.e., agents act reciprocally to the principal's wage choice. Yet, if the principal controls, the agent's reciprocal inclination is lower than if the principal does not control. The result shows that even if the principal can use additional instruments to motivate the agent, control continues to have a negative impact on agents' performance. To further test the robustness of our ¯ndings, we conducted a questionnaire where subjects were asked to state their work motivation in various everyday workplace scenarios. Similar to our lab evidence, we ¯nd that self-reported work motivation varies signi¯cantly with the extent to which agents are exposed to control. Taken together, our results show that the use of control and explicit incentives entails 1The intuition of our results is neatly captured by an example reported by David Packard, one of the founders of the computer company Hewlett-Packard (HP). Packard notes in his memoirs: \In the late 1930s, when I was working for General Electric ..., the company was making a big thing of plant security. ... GE was especially zealous about guarding its tool and parts bins to make sure employees didn't steal anything.