Institutions, Fairness, and Contract Enforcement

Abstract: This paper provides evidence on how fairness concerns affect the impact of market institutions, focusing on two particularly important institutions: dismissal barriers, and bonus pay. We implement settings with incomplete contracts and endogenous long-term relationships. Theoretical solutions to incompleteness typically involve firms using rents and firing threat to incentivize selfish workers, or else using generous wages to appeal to worker fairness concerns. Experiments show, however, that there is typically a mix of selfish and fair agents. Our paper shows that understanding the impact of institutions requires an appreciation of this heterogeneity, because some institutions allow “fairness compatible” incentives, whereas others force firms to tradeoff incentivizing selfish workers against demoralizing fair workers. In particular, dismissal barriers remove the threat of firing as an incentive device, and lead firms in our experiments to endogenously implement rising wage profiles to incentivize selfish workers. But low initial wages tend to demoralize fair workers and cause them to exert low effort, so market efficiency is low. This loss in efficiency means that dismissal barriers do not help workers. We find that introducing bonus pay largely undoes the negative effects of dismissal barriers, by allowing firms to incentivize selfish workers while also rewarding good performance by fair workers.