Eva I. Hoppe and Patrick W. Schmitz
Abstract. We present the first large-scale laboratory experiment that studies the canonical hidden action problem in the way contract theorists conceive of the problem, comparing treatments with unobservable effort to benchmark treatments with verifiable effort. In our one-shot experiment, the players endogenously negotiate contracts. In line with contract theory, the contractibility of the outcome plays a crucial role when effort is a hidden action. If outcome is contractible, most players overcome the hidden action problem by agreeing on incentive-compatible contracts. If outcome is non-contractible, in most cases low effort is chosen whenever effort is a hidden action. Even when free-form communication is possible, the players typically avoid gift-exchange situations.
The working paper version is available for download (CEPR Discussion Paper 11002).