Optimal Incentives Under Gift Exchange

Abstract

This paper studies optimal incentives in the presence of an agent’s preference for generosity, where the principal optimally chooses the level of generosity (rent) as well as the performance-based pay. We show that some minimum level of reciprocity is required for generous contracts to become attractive. More reciprocal agents exert greater effort, but they may not necessarily receive more generous offers, as our model predicts a hump-shaped relationship between generosity and the reciprocity parameter. This means that moderately reciprocal agents tend to receive a premium relative to weakly or strongly reciprocal agents. Generosity and performance-based pay are likely to behave as complements when risk-sharing motives (determined by noise in the environment and the agent’s degree of risk-aversion) are strong, and they are likely to behave as substitutes when risk-sharing motives are relatively moderate. Moreover, base-wage gifts are always optimal, whereas piece-rate or composite gifts are only optimal in a low-noise environment.