Agency and Anxiety

Abstract

In this paper, we introduce the psychological concept of anxiety into the standard linear agency model. After replacing the agent's risk premium with anxiety, we show that the agent's optimal effort can conform to the inverted-U hypothesis, which states that an increase in anxiety improves performance when anxiety is low, but reduces it when anxiety is high. It follows that high-powered incentives can backfire when they generate too much anxiety, in line with recent experimental evidence. A rational principal, however, never finds it optimal to offer such counterproductive incentives, which reconciles the seemingly contradictory empirical and experimental findings on the effects of incentives. Since anxiety can be motivational, the model explains violations of the Informativeness Principle where a principal injects noise into the contract or fails to filter it out. Finally, incentives and risk can be strategic complements for the principal with respect to generating effort, which can explain the mixed evidence for the risk-reward tradeoff.

Keywords: anxiety, incentives, informativeness principle, intrinsic motivation, risk-reward tradeoff

JEL Classification: M52, D86, L2