Reciprocity, Repeated Play, and Budget-Based Contracts

We use a laboratory experiment to investigate how the level of a budget assigned to an employee by a firm owner affects employee effort. Consistent with reciprocity and fairness models, we find a negative relationship between budget levels and employee effort - many employees responded to a low budget with high effort and responded to a high budget with low effort. We observed higher levels of reciprocal behavior (i.e., lower budgets and higher effort) when the same employee-owner dyad interacted for multiple periods relative to dyads only interacting for a single period. Further, we find that employee participation in the budget-setting process was beneficial to owners when they interacted with employees for multiple periods but detrimental to owners when they interacted with employees for only a single period. Collectively, our results help to reconcile the mixed evidence of prior empirical research examining how budget level difficulty and employee participation affect the efficacy of budget-based performance evaluation and reward systems.