Contracting with self-esteem concerns

It is widely accepted in social psychology that the need to maintain and enhance self-esteem is a fundamental human motive. We incorporate this factor into an otherwise ordinary principal-agent framework and examine its impact on the optimal incentive scheme and the agent's behavior, especially focusing on the form of intrapersonal strategy known as self-handicapping. Incorporating self-esteem concerns into a contracting situation yields an implication that runs counter to conventional wisdom; that is, the standard tradeoff between risk and incentives may break down (i.e., more uncertainty reduces agency cost and hence results in stronger incentives) in the presence of self-esteem concerns. This is because uncertainty mitigates the need for self-handicapping. This result provides a possible reason for why we do not empirically observe this tradeoff in a robust manner. We present an intuitive condition for this anomaly to arise and provide a set of testable implications. The present framework also reveals why and how team production can be made more profitable, which provides an explanation for the increasing popularity of team production. Finally, this simple logic is applied to identify additional implications for the hidden costs of external enforcers, such as evaluation and monitoring, which are discussed extensively in social psychology. (C) 2011 Elsevier B.V. All rights reserved.