Use and Abuse of Authority

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.