Is There Room within Principal-Agent Theory for Ethics?
48 Pages Posted: 28 Apr 2005
Date Written: April 20, 2005
Abstract
We study the feasibility and desirability of integrating ethics with traditional principal-agent theory. After discussing common objections and potential benefits, we present a principal-agent model that incorporates ethics in a manner that maintains the essential features of the traditional LEN framework. In our integrative model, the principal specifies a standard for effort at the time of contracting and the agent suffers a disutility if he chooses to violate the standard after agreeing to the contract. The magnitude of the disutility depends upon the level of violation and the ethical sensitivity of the agent. Setting ethical sensitivity to zero yields the traditional result that a flat salary is incapable of inducing effort from the agent. When ethical sensitivity becomes nonzero, however, a flat salary solution emerges. We examine the interplay between ethical sensitivity and firm productivity in determining the optimal salary contract. Our study suggests that incorporating ethics enhances both the internal and external validity of principal-agent theory.
Keywords: Principal-agent theory, ethics, incentives, optimal contracts
JEL Classification: A13, D82, J31, M40, M41, M46
Suggested Citation: Suggested Citation