Beliefs Over Contracts

Abstract

We study how firms choose among incentive contracts and how accurately managers predict their effects. Using a survey of managerial beliefs and a large-scale field experiment, we randomly assign agents at the market level to several widely used, expenditure-equivalent incentive schemes. In the field, the best-performing contract raises weekly firm profit by over 55% relative to the status quo, despite being ranked lower by managers, whereas the worst-performing contract performs as predicted. Managers reliably avoid poorly performing contracts but systematically underestimate top-performing ones. Standard contract theory does better as a forecaster here: an unbiased textbook principal orders the contracts correctly, or very nearly so, correctly identifying the profit leader where managers do not; where it does miss, the error is similar to managers’ and for a similar reason. We show that the performance differences across contracts reflect a mix of labor-supply and risk responses, and that managerial predictability varies with contract complexity and managerial hierarchy. Our results highlight the importance of contract design for firm performance and reveal systematic limits to managerial cognition in shaping incentives.