Reciprocal Exchange in Agency

The present paper introduces a principal-agent model in which the principal pays wages that exceed agents’ resevations values, and agents voluntarily comply with his directives even though no formal mechanisms exist to enforce these directives. We view the agency relationship as a reciprocal exchange where the principal pays rents to reduce the probability of a collective challenge. These rents create a public good problem where agents compare the benefits of participating in a successful challenge with the benefits of free-riding on others. We endogenously derive the optimal level of rents and the severity of this public good problem. The payment of these rents distorts the choice between agency relationships and alternative contractual forms. ∗Department of Managerial Economics and Decision Sciences, Kellogg School of Management, Northwestern University, Evanston IL 60208. †Graduate School of Industrial Administration, Carnegie Mellon University, Pittsburgh, PA 15213.