Contracting with Self-Esteem Concerns

It is widely accepted in social psychology that the need to maintain and enhance self-esteem is a fundamental human motive. We incorporate this factor into an otherwise ordinary principal-agent framework and examine its impact on the optimal incentive scheme and the agent's behavior, especially focusing on a form of intrapersonal strategy known as self-handicapping. Incorporating self-esteem concerns into a contracting situation yields an implication that goes against the conventional wisdom: the standard tradeoff between risk and incentives may break down in the presence of self-esteem concerns because uncertainty mitigates the need for self-handicapping, providing a potential reason for why we do not empirically observe this tradeoff in a robust manner. We characterize an intuitive condition for this anomaly to arise and present a set of testable implications. Along the way, we also show that the fragility of self-esteem (the variance) is just as important as its level (the mean) in selecting agents. Finally, this simple logic is applied to a team problem to show why and how people are better motivated under team production than under individual production.