When a principal hires an agent to perform a task, she puts herself at risk of sustaining losses resulting from the agent’s lack of effort. For example, consider a homeowner who hires a plumber to fix a pipe. The plumber can choose to put forth great effort toward a long-lasting fix or to put forth less effort toward a temporary fix. Meanwhile, the homeowner is ill-equipped to evaluate the effort put in by the specialized plumber at the time of performance. As a result, the plumber’s suboptimal performance (if chosen) is remediable only ex post, likely through expensive breach-of-contract litigation.
Because principals are often unable to observe the effort exerted by an agent, how should a principal contract with an agent when the principal knows that an agent’s lack of effort might result in a less-than-ideal outcome? One idea that has become popular in the literature is to create a liquidated-damages payment, in which the agent agrees in advance that the principal has the right to assert a damages claim under the contract if the observed outcome is less than ideal. Stipulating damages up-front offers both sides the benefit of avoiding expensive litigation to fix damages ex post.
However, Professor Ben Depoorter and his coauthors, in a new paper in the Journal of Institutional & Theoretical Economics titled “The Moral-Hazard Effect of Liquidated Damages,” offer new laboratory evidence that suggests that specifying damages ex ante can negatively affect optimal contract performance. They hypothesize that the agent comes to resent the principal for stipulating damages up-front, reducing the agent’s motivation to perform at a high level. Surprisingly, they find that relying on courts to adjudicate claims ex post does not negatively impact the agent’s motivation, even if it creates litigation costs. These surprising and important results require us to rethink the ideal way to motivate agents to perform at a high level while avoiding the cost and delay of litigation.