THE HIDDEN COSTS AND RETURNS OF INCENTIVES — TRUST AND TRUSTWORTHINESS AMONG CEOs

Abstract

We examine experimentally how Chief Executive Officers (CEOs) respond to incentives and how they provide incentives in situations requiring trust and trustworthiness. As a control we compare the behavior of CEOs with the behavior of students. We find that CEOs are considerably more trusting and exhibit more trustworthiness than students—thus reaching substantially higher efficiency levels than students. Moreover, we find that, for CEOs as well as for students, incentives based on explicit threats to penalize shirking backfire by inducing less trustworthy behavior—giving rise to hidden costs of incentives. However, the availability of penalizing incentives also creates hidden returns: if a principal expresses trust by voluntarily refraining from implementing the punishment threat, the agent exhibits significantly more trustworthiness than if the punishment threat is not available. Thus trust seems to reinforce trustworthy behavior. Overall, trustworthiness is highest if the threat to punish is available but not used, while it is lowest if the threat to punish is used. Paradoxically, however, most CEOs and students use the punishment threat, although CEOs use it significantly less.HIDDEN COSTS, RETURNS OF INCENTIVES, TRUST, TRUSTWORTHINESS, CEO