Foresighted outcome effect: A micro-foundation of agents' risk aversion in principal-agent relations

Abstract

Agents' risk aversion is a long-standing source of concern in principal-agent theory and in the practice of organizations. While standard principal-agent theory assumes that principals adequately infer conclusions from noisy outcomes, behavioral research suggests that their inferences are affected by outcome bias. We take a further theoretical step, and propose that when an agent knows that the principal's evaluation of the agent's decision will be based on outcome knowledge, the agent expects the principal to be overly affected by the outcome, rather than by the merit of the choice. As a result, the agent seeks to minimize the likelihood of an adverse outcome, leading to risk aversion. The results of three laboratory experiments support this hypothesis, suggesting that under outcome-knowledge-based principal-agent relationships, agents anticipate the effect of outcome bias on principals, and adjust their ex-ante behavior by opting for less risky alternatives, a phenomenon we call foresighted outcome effect.