Contracts, Controllability, and Fairness

Prior literature suggests that the welfare of principals and agents is increased by designing contracts that reduce the effect of uncontrollable factors on agents’ compensation. In this paper, we provide evidence that this is not always the case. Specifically, using two experiments, we show that when a favorable state of nature is realized, agents believe their compensation is less fair if they are compensated according to a state-dependent contract that reduces the effect of the state of nature on their compensation – even if they accepted the contract and viewed it as relatively fair ex ante. Furthermore, we provide evidence that this perceived unfairness can lead agents to take actions (e.g., misreporting) that adversely affect principals’ welfare. Combined, our evidence supports the notion that agents expect to be rewarded for uncontrollable factors that increase firm performance without being punished for uncontrollable factors that decrease firm performance.