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Intrinsic Motivation and Optimal Incentive Contracts

Author(s): Kevin Murdock


Source: The RAND Journal of Economics, Vol. 33, No. 4 (Winter, 2002), pp. 650-671
Published by: Wiley on behalf of RAND Corporation
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RAND Journal of Economics
Vol. 33, No. 4, Winter 2002
pp. 650-671

Intrinsic motivation and optimal incentive


contracts

Kevin Murdock*

I study the role of intrinsic motivation on optimal incentive contracts. Agents engage in efforts
to generate projects with both financial return and intrinsic value to the agent. In a neutral
environment, where intrinsic motivation has no direct effect on the disutility of effort, static
contracts are unaffected by intrinsic motivation. In contrast, the firm's profits from an implicit
contract are increasing in the degree to which the agent is intrinsically motivated, showing that
implicit contracts and intrinsic motivation are complements. The results are further extended to
consider the role of multiple implicit contracts and product market strategy.

1. Introduction

* Economists traditionally model the employment relationship using a principal-agent model


(Holmstrom, 1979) in which the principal offers an incentive contract to induce the agent to
engage in an unpleasant task (effort) that is necessary to create valuable output for the principal.
The core of the transaction is one where the principal offers extrinsic rewards to compensate
the agent for the disutility of effort. Implicit in this formulation is the idea that the agent has no
positive incentive to create output in the absence of the incentive contract offered by the principal.
This article takes as its starting point the notion that individuals care about what they do,
in addition to what they are paid. In other words, people value and therefore derive utility from
characteristics of the output of their work in addition to how much they are paid for that work.
Therefore, the primary objective of this article is to examine the effect on optimal incentive
contracts when agents respond to intrinsic motivation.
Social psychologists and sociologists describe that there are two sources of intrinsic moti-
vation: task involvement and goal identification. ' Task involvement denotes the degree to which
an agent derives utility from the actual performance of a task. From an economic perspective,
task involvement would be modelled simply as a lower disutility of effort for the agent, and it
is not the subject of this article. Rather, I focus here on the implication of goal identification.
Under goal identification, agents have objectives for accomplishment that are independent of any
financial reward. Galbraith describes these goals as an important component of agent incentives,

* Stanford University and McKinsey & Company; kevin-murdock@mckinsey.com.


I am grateful to Jay Bhattacharya, Thomas Hellmann, Scott Hemphill, Ed Lazear, Canice Prendergast, Patrick Rey,
John Roberts, Garth Saloner, seminar participants at the Graduate School of Business at Stanford University, the University
of Michigan Business School, and the University of California, Los Angeles for helpful comments and discussions, as
well as for the comments of two anonymous referees. Any remaining errors or omissions are my own.
1 See, for example, Galbraith's description of intrinsic rewards and the implication for organizational design
(Galbraith, 1977) and Staw's discussion of extrinsic and intrinsic motivation (Staw, 1989).

650 Copyright ? 2002, RAND.

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because "the achievement of these goals, then, is regarded as higher level needs. In turn, behaviors
perceived to be instrumental to the attainment of these goals acquire an instrumental value and
become intrinsically rewarding" (Galbraith, 1977, p. 336).
That intrinsic motivation may be an important factor in an agent's effort decision should
not be surprising to an academic reader. After all, few people in an academic field believe that
they engage in research to capture incentive payments associated with the publication of a paper.
Extrinsic rewards in academic environments are muted at best, and it would be difficult to explain
the productivity of research on the basis of incentive payments alone. Rather, most academics
engage in research because they value research output independent of its financial return.
Of course, an economist treads on dangerous ground once he ventures to make assumptions
about what enters the agent's utility function. Intuitively obvious results (such as "agents work
harder when their disutility of effort is lower") can be transparently generated. This article will
avoid such difficulties by examining the issue in an underlying environment where intrinsic
motivation has a neutral effect on the disutility of effort. In particular, I shall examine a situation
in which the agent engages in effort to generate projects and those projects generate both a
financial return (that accrues to the firm) and an intrinsic return (that accrues to the agent). A
neutral environment is one in which the average intrinsic return is zero. Note, however, that even
though expected intrinsic returns are zero, there will be projects generated that have both positive
and negative intrinsic return.
If intrinsic motivation does not affect the agent's disutility of effort directly, then how can it
affect the optimal incentive contract? I develop here two key ideas. The first is that when the agent
is intrinsically motivated, there are potential gains from trade that do not exist when the agent
responds only to extrinsic incentives. The surplus generated by a project is the combined value
of the financial return plus the intrinsic return of the project. Therefore, there are some projects
with positive surplus but negative financial return. Under this circumstance, it is efficient for the
firm to implement a loss-making project, provided that the agent knows the firm will do so when
she makes her ex ante effort decision. The trade implicit here occurs when the firm commits to
implement this class of projects in exchange for the agent's working harder to generate projects in
the first place. This type of trade, however, is not feasible when the agent is extrinsically motivated,
because all projects with negative financial return then also have negative total surplus.
The second key idea is that those gains from trade are difficult to realize, because the firm and
the agent cannot contract directly on the intrinsic return generated by a project. Thus, contracts
are necessarily incomplete when agents are intrinsically motivated. It is a natural assumption that
intrinsic returns are noncontractible because it is difficult to imagine that a court could verify the
amount of utility that the agent derives from a project being implemented. As a consequence,
the optimal static contract cannot be contingent on intrinsic returns, which implies that intrinsic
motivation has no effect in a neutral environment.
In a dynamic setting, however, the firm can improve upon this result by the enforcement of
an implicit contract between the firm and agent. Essentially, the firm commits to implement some
projects where the realized returns have a positive intrinsic return but a negative financial return
to the firm. The net effect is that the expected intrinsic return to the agent, conditional on the
firm's implementing the project, is positive. An intrinsically motivated agent will respond with
higher effort incentives, generating more projects and therefore increasing the firm's expected
return. The firm's commitment is credible provided that the current-period cost associated with
implementing each project is less than the discounted value of higher future profits generated by
maintaining the implicit contract.
Essentially, the gains from trade are realized intertemporally, where the agent is compensated
with high intrinsic returns in some periods in exchange for higher effort levels (and therefore
greater profits for the firm) in other periods. These gains from trade are increasing in the degree
to which the agent is intrinsically motivated. As a consequence, the incremental value of moving
from a static contract to an implicit contract is increasing in the degree of intrinsic motivation.
Thus, intrinsic motivation and implicit contracts are complements.
The implicit contract between the firm and the worker essentially performs the role of an
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652 / THE RAND JOURNAL OF ECONOMICS

insurance contract. When the agent generates a positive-surplus, negative-profit project, the
marginal utility of income is particularly high because if the agent had sufficient wealth, she
would pay the firm to implement the project. Insurance contracts conditioned on the agent's out-
put are infeasible, however, because this output is not verifiable. Instead, the implicit contract
between the firm and agent serves the role of this insurance function.
It is worth noting that the firm is limited in its ability to provide this insurance function
because, due to the incentive-compatibility constraint, there is a limit to the extent to which
the firm can credibly invest in negative-financial-return projects. When the agent is intrinsically
motivated, this constraint may bind for projects that have large negative financial returns and yet
still have positive surplus due to large positive intrinsic benefits. If the firm can engage in multiple
implicit contracts, however, it can borrow slack from one constraint to relax a binding constraint
elsewhere. Thus, the firm may optimally engage in multiple implicit contracts to enhance its ability
to credibly invest in these exceptional projects. This result strongly parallels that of Bernheim
and Whinston's (1990) analysis of multimarket contact, where again the central idea rests on the
firm's ability to pool constraints. What is different in the present context is the importance of
intrinsic motivation in generating outcomes where multiple implicit contracts create efficiency.
When agents are extrinsically motivated and the firm is farsighted, then the firm can always
implement the first-best outcome with a single implicit contract. In contrast, when agents are
intrinsically motivated, there are always projects that should be efficiently implemented, but the
firm cannot commit to do so.
A final set of results considers the relative efficiency of static and implicit contracts when
financial and intrinsic returns are correlated as opposed to independent. When returns are cor-
related, incentives between the firm and the agent are closely aligned and so static contracts are
relatively more efficient. In contrast, correlated returns harm the efficiency of implicit contracts
because gains from trade are limited. As discussed above, implicit contracts enable trade when a
project has positive surplus but negative financial return. These outcomes are less frequent under
correlated returns compared to independent returns.
If the product market strategy of the firm affects the degree to which financial and intrinsic
returns are correlated, this final set of results has implications for what combinations of product
market strategy and human resources strategy we are likely to observe among firms. For example,
firms engaged in a patent-race style of competition that hire workers who are motivated by the
opportunity to create new technology are likely to find that the financial and intrinsic returns of
a project are correlated. For these types of firms, our results predict that we are more likely to
observe static contracts. Saxenian (1996) describes how firms form around projects in Silicon
Valley then break apart and reform as new opportunities arise. This description is consistent with
a model based on correlated returns and static contracts. In contrast, firms engaged in service
businesses that hire workers who care about the impact of their work on the customer are likely
to see less correlation between financial and intrinsic returns. Workers, for example, may prefer
to overinvest in quality relative to what maximizes the firm's profits. In this circumstance, there
are greater opportunities for gains from trade, and so the model predicts that we are more likely
to observe long-term relationships and implicit contracts between the firm and its workforce.
The economics literature examining intrinsic motivation is still in its infancy. Kreps (1997)
discusses the impact of extrinsic incentives on intrinsic motivation with a discussion of how
preference formation may affect economic incentives. Lindbeck (1995, 1997) discusses how social
norms may affect behavior as agents engage in activities to capture rewards mediated through
a social structure. Frey (1997) and Frey and Oberholzer-Gee (1997) both model how extrinsic
rewards may adversely affect intrinsic motivation and then present empirical tests measuring
the effect of "motivation crowding out." The above articles focus either on the role of norms in
providing incentives or on the potential substitutability of extrinsic and intrinsic rewards. The
emphasis of the present article is placed instead on the implications of the intrinsic motivation of
the workforce for the noncontractible decisions made by the firm. A key result is that it is optimal
for the firm to condition its investment decisions based on the preferences of its employees.
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Articles by Aghion and Tirole (1997) and Baker, Gibbons, and Murphy (1999) are most
closely related to this one. Both of them also focus on how the principal's ability to commit to
implementing a set of projects ex post affects the agent's effort incentives ex ante. The present
article differs from these in its emphasis on how this commitment is generated. In particular,
both Aghion and Tirole and Baker, Gibbons, and Murphy emphasize how characteristics of the
principal affect the ex post commitment, whereas I emphasize the role of characteristics of the
agent. For example, Aghion and Tirole analyze formal delegation of authority, and when that is
not possible they discuss how information overload of the principal can commit him to being
uninformed and hence convey "real authority" to the agent. Baker, Gibbons, and Murphy also
emphasize the role of how the information structure available to the principal affects his ability to
commit. In their model, sometimes it is preferable for the principal to know the expected returns
before he approves the agent's recommendation, and sometimes it is better if he learns the returns
only after approval. In contrast, my emphasis is on how changes in the agent's intrinsic motivation
affect the firm's ability to make an ex post commitment. As the agent's intensity of preference
for intrinsic rewards increases, the agent becomes more responsive to the firm's commitment
to implement (modestly) negative-NPV projects that have high intrinsic rewards. The increased
effort by the agent then makes it in the firm's self-interest to honor the commitment.
The article is organized as follows. A motivating example is presented in Section 2. Section 3
introduces the basic principal-agent model, where the agent may have intrinsic motivation based
on intrinsic return from projects generated by the agent. Section 4 then derives the optimal static
contract and demonstrates the result that intrinsic motivation has no effect on static contracts
when the environment is neutral (i.e., the unconditional expected intrinsic return is zero). Section
5 develops properties of the optimal implicit contract in this setting. First, the expected intrinsic
return, conditional on the firm implementing the project, is positive. Second, the incremental
value of implicit contracts and degree to which agents have intrinsic motivation are complements.
Section 6 next demonstrates that when agents are intrinsically motivated, the firm may optimally
engage in multiple implicit contracts where it conditions its willingness to implement one project
on the realized returns generated by other projects. Section 7 next derives the relative return of
static and implicit contracts when returns are correlated, showing that static contracts are more
valuable when returns are correlated and implicit contracts are more valuable when returns are
independent. A conclusion follows in Section 8.

2. A motivating example

* Motivation for this article can be seen in Merck's decision to develop, produce, and distribute
the drug Mectizan as a cure for river blindness. The firm's actions were largely consistent with the
predictions of Propositions 3, 4, and 5 in this article. "Merck had built a researcher team dedicated
to alleviating human suffering" (Hanson, Bollier, and Weiss, 1991a, p. 4), so it is plausible that
Merck's researchers are intrinsically motivated, with a goal of developing novel drug therapies.
People afflicted with river blindness live in poor, remote areas of the developing world, so it was
also clear ex ante to Merck that the project had a negative net present value. Dr. Roy Vagelos, at
that time the head of Merck's research labs and later CEO of the company, admitted that "we knew
that it was going to be a borderline economically viable project at the start." (Hanson, Bollier,
and Weiss, 1991b, p. 1). Later, Vagelos stated, "We had never undertaken the development of a
drug that was going to be broadly used, such as 18 million patients, with the idea that we were
not going to make money." (Hanson, Bollier, and Weiss, 1991b, p. 2).
Despite this, Merck decided to develop, produce, and then give the drug away for free.
There were two main reasons for this action. First, while the project had a negative NPV, the
drug offered a complete cure for a gruesome disease and Merck was concerned about the adverse
impact that not producing the drug would have on the morale of its researchers. In essence, the river
blindness cure had the characteristic of a negative financial return with a large positive intrinsic
return. Second, the division had developed a related drug, ivermectin, that was very profitable.
In deciding to give the drug away, "one factor that helped Merck come to its decision was the
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success of ivermectin as a veterinary drug. Even if the Mectizan donation ended up costing tens
of millions of dollars, at that time ivermectin was reaping more than $300 million a year, with
sales growing by 15% annually." (Hanson, Bollier, and Weiss, 1991c, p. 1). A Merck senior vice
president told the Wall Street Journal that "we can easily afford this." (Hanson, Bollier, and Weiss,
199 1c, p. 1). Most economic analysis would claim that this kind of linkage is not consistent with
profit-maximizing behavior. Proposition 5 below will provide theoretical evidence for why that
decision and reasoning may have been optimal for Merck.
There are two other candidate explanations for why Merck chose to develop this drug, but
they are not as consistent with the events as the one developed in this article. The first is that
Merck invested in a cure for river blindness due to research complementarities from the learning
that would take place during the development of the drug. While this might partially explain
Merck's incentives to engage in early-stage research, it does not explain why Merck proceeded
to clinical trials, where the vast majority of the expenses are incurred. Further, taking the drug to
human clinical trials risked imposing a negative externality on the company because an adverse
reaction to the human drug could have harmed sales of the veterinary drug, ivermectin. A Merck
researcher stated that there was "a lot of turmoil in the company about whether we should expose
this fabulous commercial product to the risk of human usage." (Hanson, Bollier, and Weiss, 199 lb,
p. 2).
The second candidate explanation is that Merck developed the drug for its public relations
value. In the end, Merck did enjoy substantial positive coverage of its decision. Once Merck had
developed a drug so efficacious that a single dose would cure a patient for a period of a year, the
commitment to provide the drug for free potentially made sense on a PR basis. But at the time that
the significant investment was being made to deploy human clinical trials, Merck did not know
whether the drug would be either safe or efficacious, let alone that it would cost so little to provide
such a potent therapy. At the time of the decision, it is more credible that the potential adverse
impact that human trials could have on a $300-million-per-year drug weighed at least as heavily
against going forward as the potential PR benefits of success weighed in favor. Throughout the
decision process, the intrinsic value that Merck's researchers placed on developing a drug that
would have a significant positive impact on 18 million sufferers would always favor the firm's
proceeding with development.

3. The model
* I consider a setting where an agent can expend effort to generate a project. Projects are
characterized by two parameters: v, the financial returns associated with the project, and s, which
represents characteristics of output that are valued by the agent but are orthogonal to the financial
returns associated with implementing the project. Some examples of project characteristics that
may be embodied in this nonpecuniary characteristic include the size of the consumer surplus
generated by the project (but, of course, not captured by the firm) and the degree to which
the technology in the project represents "cutting edge" or state-of-the-art technology. What is
important about these characteristics is that they describe aspects of the project that may be
valued by the agent, independent of the financial rewards generated by the project.
At the time that the agent decides how much effort to invest in generating the project, the
precise payoffs to the project are unknown, but the agent knows the distribution of returns that
might be generated, F(v, s), with f(v, s) > 0. Initially, I will assume that financial and intrinsic
returns are independently distributed, i.e., F(v, s) = G(v)H(s), but I will relax this assumption in
later sections. The process of generating project ideas is uncertain, but the more effort the agent
invests, the greater the probability that the agent successfully generates a project idea. I model
this by assuming that the agent can choose p, the probability of generating a project, at cost c(p
where c'(p) > 0, c'(0) = 0, c'(1) -- oc, and c"(p) > 0.
Both the firm and agent are risk neutral. The firm maximizes expected profits and the agent
maximizes expected utility where u(y, s, p) = y + as - c(p), with y representing the expected
income of the agent and (x representing the degree to which the agent derives intrinsic rewards
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from the nonpecuniary characteristics of the project. The firm discounts future returns with the
discount factor, S. The agent has limited liability, which is formalized by the assumption that the
agent must earn an income of at least w0 in any period.2 This can be justified on the basis that the
agent is wealth constrained and therefore unable to make arbitrarily large transfers to the firm in
order to increase the efficiency of the agency relationship.
There are two ways to model the effect of intrinsic motivation on incentives, depending on
whether intrinsic motivation is a characteristic of the agent or a characteristic of the task. The
parameter a captures intrinsic motivation as a characteristic of the agent. As a rises, the intensity
of the agent's preferences over the intrinsic returns increases. A person with high a will have a
very positive reaction to an s > 0 project such as a drug that cures a gruesome disease. Similarly,
a person with a high a will have a very negative reaction to an s < 0 project such as one that
degrades the environment through pollution. It seems natural to parameterize intrinsic motivation
by the intensity a because individuals tend either to care highly about both good and bad outcomes
or to not be very responsive to either.
The parameter 0 captures intrinsic motivation as a characteristic of the task. 0 is a mean-
preserving spread of the distribution of intrinsic rewards H(s, 0). Following Rothschild and
Stiglitz (1970), for 01 > 02, if

{00 {00
f sdH(s, 01) = f sdH(s, 02), (1)

then

f H(s, 01)ds > f H(s, 02)ds. (2)


00D J00

An increase in 0, then, represents an increase in the spread of intrinsic returns generated by


the project. A high-0 project has greater variability in the types of intrinsic rewards generated by
that task.
I am assuming that the effort p of the agent is neither observable nor verifiable. The firm only
observes whether the agent generates a project. I further assume that the financial and intrinsic
returns to any project idea are observable to both the firm and the agent but are not verifiable by
outside third parties.3 Any project idea generated by the agent will depend in part on access to
other assets owned by the firm. The firm will grant the project access to those assets only if it
decides to implement the project. The financial return of the project is the incremental marginal
product of the use of those assets over their next-best available use. Although this incremental
return may be observable within the firm, it is not verifiable to an external court. With respect to
intrinsic returns, while both the firm and the agent may observe the degree to which this project
generates intrinsic returns for the agent, the characteristics of the project upon which this return is
based are inherently difficult to measure and verify. If, for example, the characteristic from which
the agent derives utility is the "impact" of the project (where impact is determined by the size of
the consumer surplus generated by the project), then it would be difficult to generate a verifiable
statistic that measures this characteristic.
The creation of effort incentives in this environment then becomes an important issue. The
property-rights view of the firm (Grossman and Hart, 1986; Hart and Moore, 1990) studies how
effort incentives can be generated when output is noncontractible. Models along these lines,
however, emphasize investments in human capital, where if the agent withdraws her participation
(human capital) the value of the output decreases, giving her bargaining power. My model analyzes

2 An alternative and equivalent assumption is that the agent is risk neutral for income above and infinitely risk
averse for income below that threshold.
3 Because both the firm and the agent are risk neutral, I do not need to assume that the actual returns are known
with certainty. Rather, an equivalent interpretation would be that v and s represent the expected returns of the project,
should the firm choose to implement it.

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investments in intellectual capital (ideas) where once the idea is generated, the agent is no longer
critical to output, so the firm can capture all of the surplus financial return v - b.
In this model, one pair of actions is both observable and verifiable-when the agent proposes
a project and the firm implements.4 Let us assume that the firm can write a contract to pay the
agent b when it implements the agent's project. There are a number of potential interpretations
of b. The simplest is that b is a contractual obligation enforced by the courts, and the above set
of assumptions justify that interpretation, but this is not wholly satisfying because we do not
frequently observe these kinds of contracts in practice. Rather, the preferred interpretation is that
when an agent's project is implemented, this is a positive signal about the capabilities of the
agent.5 This signal will then be observed by other competing firms that will bid up the future
wage of the agent. The financial reward, b, is thus the agent's expected return from generating that
signal. Given this interpretation, there may be some question as to how much the firm can thus
manipulate b. There are two responses. First, the firm does have some influence over the size of
b. It can establish a practice of publicizing "heroes" who come up with successful ideas, or it can
promote a more anonymous "team-oriented" culture that makes it less clear who deserves credit.
Second, even if b were fixed and outside the firm's control, my results (which focus on intrinsic
motivation and implicit contracts and do not depend on the level of b) would still hold.6
In this environment, the incentive scheme that the firm can offer the agent is made up of
a fixed wage w0 (satisfying her finance constraint) and a bonus payment b, which is contingent
on the firm's implementing the agent's project. For expositional simplicity in the remainder of
the article, I will assume that the agent's wealth constraint is binding and, as a consequence, the
agent's individual rationality constraint is not.7 Without loss of generality, we can normalize wo
to be zero.

4. Static contracts
* Let us begin with an analysis of the outcomes that can be implemented by the firm using
static contracts as described above. The sequence of moves begins with the firm offering a bonus
payment b to the agent. If the agent accepts the contract, she engages in an effort p to generate
the project. Should the agent successfully generate a project, both the firm and the agent observe
the realized values of v and s. The firm can choose to not implement the project or else invest
in the project and pay the agent the bonus payment b. As the agent decides how much effort to
invest, she looks forward to determine what set of projects the firm will implement-only those
projects with nonnegative net income for the firm (v > b). One issue that this raises is whether
the firm and the agent could renegotiate their contract so that the firm could implement projects
with 0 < v < b by paying a lower incentive payment. If b is a simple contractual payment, then it
can probably be renegotiated, but if b arises because other firms will bid up the reservation wage
of the agent, then the firm and agent cannot renegotiate. Whether renegotiation is possible is not
critical for my results. The qualitative results presented still hold under renegotiation at a cost of
increased analytical complexity that does not provide any additional insights.
She will then determine her effort level to maximize her expected utility,

u(b, p) = p f f(b + oas)dF(v, s) - c(p),


v>b

4 It may also be the case that the agent submitting a proposal is verifiable as well. If, however, the agen
costlessly generate a worthless proposal, the firm would never reward proposal generation.
5 Consider, for example, that there are two types of agents, effective and (relatively) ineffective, where d
dci /dp, but firms cannot observe the agent's type. Since the probability of generating a worthwhile project is h
the effective type, implementing a project conveys information about the agent.
6 Rotemberg and Saloner (1993) describe in greater detail how a firm can influence these outcomes.
7 If the agent's wealth constraint is not binding, then the agent could pay the firm to implement projects wit
psychic rewards. Implicitly, here I am considering projects for which the cost of implementation is large relativ
agent's wealth, so these kinds of side payments are not feasible.
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MURDOCK / 657

which we can simplify due to the assumption that v and s are independently distributed to be

u(b, p) = p(l - G(b))[b + aE(s)] - c(p),

where

E(s) = sdH(s, 0).

The expected intrinsic return (E(s)) can be viewed as a summary statistic that represents the
attractiveness of the environment for agents who are intrinsically motivated. We can now solve
the first-order condition of the agent's effort problem:

c'(p) = (1 - G(b))[b + aE(s)], (3)

which implicitly defines the agent's effort under s


bonus payment and the intensity of her preferences for
a depends on the environment (sign { aps / aa } = sign
(where E(s) > 0), then the greater weight the agent places on intrinsic rewards, the more effort
she will expend in generating new projects.
The firm then maximizes its profit subject to the agent's choice of effort as determined by
the bonus rate b. That is,

100

7s (u) = max ps(b, al) (v - b)dG(v),


b

which yields a first-order condition of

2? fb(v - b)dG(v) = ps(b, a)[l - G(b)].

The key issue here is how a change in a affects the profitability of the static contract. The net
effect depends on the attractiveness of the environment in generating intrinsic returns. By the
envelope theorem, we have

d~rs aaps.
0s | (v-b)dG(v). (4)
da au J

When projects, on average, generate positive intrinsic rewards, agents


vated are induced to increase their effort level, compared to the base case
no expected intrinsic rewards. This results in a more profitable static
holds. This is summarized in Proposition 1.

Proposition 1. The profitability of the static contract depends on attractiveness of the environment
in generating intrinsic returns. Profits are increasing in the degree to which the agent is intrinsically
motivated in an attractive environment and decreasing in a poor environment (sign{aps/aa} =
sign{E(s)}). In a neutral environment (where E(s) = 0), profits from the static contract are
independent of the intensity of the agent's preference for intrinsic rewards, a.

This result is quite natural. Agents who are more responsive to intrinsic rewards (in the
sense of higher a) have a greater utility of effort when the expected intrinsic reward is positive,
implying a greater output for any given explicit incentive and thus ensuring that the firm will earn
greater profits. Similarly, in a poor environment (where E(s) < 0), a high-a agent will react more
negatively to the bad expected outcome, so her effort is adversely affected. Since static contracts
depend solely on the expected intrinsic return and not the distribution of returns, a natural corollary
with respect to mean-preserving spreads follows:
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658 / THE RAND JOURNAL OF ECONOMICS

Corollary 1. The profitability of the static contract is independent of a mean-preserving spread


of the distribution of returns (dhrz/dO = 0).

An important implication of these results is that when the expected intrinsic return is zero,
intrinsic motivation has no effect on the optimal static contract. This will be useful in the following
sections because, by examining implicit contracts in neutral environments (i.e., when E(s) = 0),
we can isolate the effect that intrinsic motivation has on implicit contracts.

5. Implicit contracts

* The static contract described above is inefficient because there are projects with positive
surplus (i.e., v + as > 0) generated by the agent that are not implemented by the firm. In
particular, projects with a small, negative financial return but with large, positive intrinsic return
will never be implemented by the firm in the static contract even though it would be efficient to
do so. The financial return of these projects does not equal the cost of implementation for the
firm, so the firm does not internalize the value that the project generates for the agent (both in
compensation and intrinsic return). This inefficiency arises because the firm and the agent cannot
write contracts governing firm behavior that is conditional on the intrinsic return that accrues to
the agent.
If we were to allow the firm and the agent to renegotiate the bonus payment b for projects
with v < b, then the firm could implement all projects with both positive financial return and
positive surplus (i.e., v > 0 and v + as > 0). The firm could not, however, implement any
projects with negative financial return under a static contract because the firm would lose money
and the finance-constrained agent could not compensate the firm for the loss. But as we shall see,
under an implicit contract, the firm could implement at least some negative-return projects, so
the qualitative results derived in this and subsequent sections could similarly be derived were this
assumption to be relaxed.
Because the firm and the agent may engage in a long-term relationship, it is natural to
investigate the role of implicit contracts in addressing this inefficiency. Implicit contracts offer
the opportunity to increase efficiency by changing the outcomes of noncontractible events. In
particular, while in the static contract the firm will implement only projects that net it a positive
return, under an implicit contract, the firm can promise to implement (at least some) projects that
yield positive surplus but are unprofitable for the firm. In response, the agent will choose a higher
effort level because her expected utility of effort will increase with this commitment from the
firm. The firm will abide by the commitment, provided that the increased effort from the agent
generates enough additional profitable projects to compensate the firm for its cost. Thus, the core
of the implicit contract is the exchange of greater effort from the agent in return for this promise
from the firm.
Because implicit contracts can be conditioned on outcomes that are observable but not veri-
fiable, the firm has additional degrees of freedom in designing the implicit contract. In particular,
the implicit contract can specify whether the firm should implement the project (I(v, s)) and
a noncontractible transfer payment (t(v, s)) in additional to the contractible bonus payment b.8
Under an implicit contract, then, the firm can undertake some actions ex post that yield it lower
realized profits than if it had followed the actions prescribed for it under the static contract.
The key issue then is to determine whether the firm can credibly commit to honoring the
implicit contract. Abreu (1986, 1988) has shown that any implicit contract that is enforceable can
also be enforced by an equivalent implicit contract where parties impose the maximum punishment
on the defecting party. The maximum punishment in this setting has a particularly simple structure
because the firm can always defect in one period, hire a new agent in the following period, and
offer the static contract to her. Thus the maximum punishment that the agent can impose on the
firm is simply the infinitely repeated static Nash equilibrium.

8 I(V, s) = 1 when the firm should implement the project and l(v, s) = 0 otherwise.
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Assuming that the implicit contract is credible, the agent will choose her effort level to
maximize her utility,

u(b, I, t, p) = p [y(b, I, t, 0) + a E(s I = 1) Pr(I = 1)] - c(p),

where

y(b, I, t, 0) = f f[I(v, s)b + t(v, s)]dG(v)dH(s, 0)

is the agent's expected financial income conditional on generating a project and

E(s I I = 1) Pr(I = 1) = f I(v, s)sdG(v)dH(s, 0)

is the expected intrinsic return conditional on the agent's generating a project and the firm's
implementing it. The agent's first-order condition yields

c'(p) = y(b, I, t, 0) + a E(s I = 1) Pr(I = 1), (5)

which implicitly defines PC(b, I, t, a, 0).


The firm's expected income, conditional on implementing the project generated by the agent,
is

R(b, I, t, 0) = f f[I(v, s)(v - b) + t(v, s)]dG(v)dH(s, 0).

The firm will then maximize the following program:

7rc(a, 0) = max pIc(b, I, t, a, 0)R(b, I, t, 0) (P1)

subject to

I(v, s)[b + t(v, s) - v] < SAV (IC+)


[I - I(v, s)][v - b + t(v, s)] < SAV (IC-)
t(v, s) < SAV (T)
t(v, s) > 0, (F)

where

AV 1 -8 (ric(a, 0 | b, t, I) - 7s(a)).

Constraint (IC+) arises because of the limit to which the firm can credibly imple
that yields it negative profits in the current period. If the project generates large lo
cannot implement it no matter how great its intrinsic returns. Similarly, constrai
that the firm suffers the opportunity cost of v - b when it chooses not to impleme
there is a limit to the opportunity cost it is willing to suffer to avoid imposing a ne
return on the agent. Constraint (T) arises because the firm could always choose no
and revert to the explicit contract, which creates an upper bound on the noncontrac
firm can credibly transfer to the agent. Constraint (F) reflects my assumption th
compensate the firm to implement projects due to her finance constraint.
The form of the optimal implicit contract will depend on the distribution of
the agent successfully generates the project (F(v, s)). The implicit contract will
valuable when there is a high density of projects that have a small negative financ
large positive intrinsic return. When the firm commits to implement these projects, it c
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a large increase in worker initiative (as measured by Plc - ps) because the agent is
by the expectation of a significantly higher intrinsic return. In contrast, these types of projects
cannot be implemented under a static contract.
One key property of the optimal implicit contract thus will be how the agent's expected
intrinsic return will be affected under the implicit contract. My claim is that the intrinsic return
from implemented projects is strictly greater than the first moment of the distribution of returns.
This should be clear from the impact of intrinsic returns on the payoffs to the firm and the agent.
Given the financial return to a project, v, the firm is indifferent to the intrinsic return, s. Thus,
anytime the firm will implement only a fraction of the projects with a given financial return, it
will optimally choose to implement those projects with the highest intrinsic return. This is stated
formally in Proposition 2 and proved in the Appendix.

Proposition 2. In an optimal implicit contract, the firm chooses to implement projects to ensure
that the conditional expected intrinsic return is strictly greater than the unconditional return (i.e.,
E(s I = 1) > E(s)).

We can now examine my central claim: that implicit contracts and intrinsic motivation are
complements in neutral environments. The intuition comes first from recognizing that a neutral
environment implies that firm profits under a static contract are unaffected by intrinsic motivation
(this is simply restating Proposition 1). Under an implicit contract, however, the agent will expect
to capture a positive intrinsic return. Either the firm will choose to implement some loss-making
projects that yield it a negative financial return, or it will not implement some profitable projects
that impose a negative intrinsic return on the agent (this is the implication of Proposition 2). This
implies that the agent's effort incentives are increasing in the degree to which she is intrinsically
motivated (i.e., apIc/aot = (l/c"(p))E(s I I = 1) Pr(I = 1) > 0). By the envelope theorem,
we can show that profits from an implicit contract are increasing in intrinsic motivation (i.e.,
a0rlc/l? = (apIc/aa)R(b, I, t, 0) > 0). This result is summarized in Proposition 3.
Proposition 3. Intrinsic motivation and the incremental value of an implicit contract are comple-
ments in a neutral environment (i.e., (d/da)[LrIc(a, 0) - 7rs(a)] > 0 when E(s) = 0).
The main point of Proposition 3 is that the value of an implicit contract increases as the
intensity of the agent's preference for intrinsic rewards increases. The greater is a, the more
valuable it is for the firm to switch to an implicit contract. This is a stronger statement than
saying simply that the profits from an implicit contract are greater than the profits from a static
contract. Given that there is inefficiency in the static contract, implicit contracts can always
improve the outcome, even when a = 0 (i.e., wrc(O) > rs(O)). The stronger claim made by
Proposition 3 is that the incremental gain from moving to an implicit contract increases with a
(i.e., 7ic(a) - 7s(a) > wrc(O) - 5s(O)).
An interesting implication of this result is that there must exist a range of environments in
which intrinsic motivation has opposing effects on the profitability of static and implicit contracts.
Consider a modestly negative environment where E(s) = -s but E(s I = 1) > 0. That is, the
average project generated is slightly distasteful to the agent but the firm can use the implicit
contract to select projects such that the average implemented project is valued by the agent. An
increase in intensity of the agent's preference for intrinsic rewards, a, harms profitability of static
contracts (because sign{aws/aa} = sign{E(s)}), whereas it will improve the profitability of an
implicit contract (because sign{arIC/aa} = sign{E(s I I = 1)}).
As a consequence, in these modestly negative environments we would expect two distinct
modes of human resources strategy. In the first mode, the firm would offer static contracts and
attract people relatively unresponsive to intrinsic rewards. In the second mode, the firm would
commit to an implicit contract where its investment decisions are conditioned on the preferences
of its workforce and it would invest in screening to hire workers who are highly responsive to
intrinsic rewards.
We can also consider how changes in the intrinsic returns to the task will affect the optimal
implicit contract. As discussed in the previous section, we model this by a mean-preserving spread
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MURDOCK / 661

in the distribution of s. The main impact of a mean-preserving spread for our purposes is that it
puts greater weight on the right tail of the distribution. This is beneficial under implicit contracts
because (as shown in the proof of Proposition 2) the optimal implementation region is the right tail
of the distribution. This makes sense. For any given financial return, the firm wants to maximize
the intrinsic return to the agent.
The point here is that any mean-preserving spread increases the profitability of the implicit
contract. After a mean-preserving spread, the firm can choose an implementation region such
that the per-project financial returns to the both the firm and the agent are preserved and yet the
realized per-project intrinsic return for the agent has increased. The increase in intrinsic rewards
increases the agent's effort incentives and so more projects are generated, increasing the firm's
total profits. This is formally stated in Proposition 4 and proved in the Appendix.

Proposition 4. Implicit contracts become more valuable to the firm when distribution of intrinsic
returns experiences a mean-preserving spread (i.e., (d/d0)[7rzc(a, 0) - 7s(a)] > 0).

As with the comparative static result on a, this is a statement of complementarity. The gain
from an implicit contract is increasing when the distribution of intrinsic returns experiences a
mean-preserving spread. Thus, regardless of whether we want to consider intrinsic motivation as
a characteristic of the agent (i.e., a) or a characteristic of the task (i.e., 0), we find that intrinsic
motivation and implicit contracts are complements.
The last comparative static result is with respect to S. It is straightforward to show that
(d/dS)[7Ic(a, 0) - Trs(a)] > 0. When B = 0, TrIc(a, 0) = rs(a), and when B -* 1, 7rIc(a, 0) -*
rlst(a, 0) the first-best outcome. Increases in S simply relax the incentive-compatibility constraints
in P1. Of course, in any economic setting B < 1, and the incentive-compatibility constraints may
bind. Then it would be beneficial for the firm if it could relax those constraints. With this in mind,
I now examine the role of multiple implicit contracts.

6. Multiple implicit projects


* In the implicit contract between the firm and the agent, the firm will sometimes implement
a project with negative financial return because the intrinsic return to the agent is very large. The
firm's ability to do so, however, is limited by its incentive-compatibility constraint (IC'). When
that constraint binds, the firm's profits would increase if it could credibly extend its promise to
implement these types of projects. Figure 1 shows an example. The firm can implement projects
in the shaded region (where I(v, s) = 1) but it cannot implement the project s1, v1 because
v1 < b-SAV.9
The main idea of this section is that if the firm is engaged in multiple implicit con
be able to implement the project sl, v1 if it has sufficient slack due to high financia
a second project, S2, v2. In particular, if V2 > b, then there is always slack in th
from the second project.10 The implicit contract takes on a new characteristic. In
promises made in the optimal (single) implicit contract, the firm can make a new
jointly enforcing multiple implicit contracts. The firm promises to implement so
projects highly valued by the agent (i.e., si, vj) when the other agent generates
a high financial return (i.e., S2, v2). In this way, the firm's optimal decision rule
project is conditioned by the performance achieved by the other agent.
Formally, consider a setting in which the firm hires two agents, and each ag
same effort decision as described in Section 3. That is, each agent can generate a project with
probability pi at a cost of c(pi), where the returns of the generated project are independent and
identically distributed by F(v, s).11 Because the underlying returns are identical across the two

9 IC' requires b + t(vl, si) - v1 < SAV whenever I(vl, sl) = 1. When this constraint is binding, the firm will
choose t(vl, sl) = 0, yielding the condition that v1 > b - SAV in order to implement the project.
10 Again, the IC+ requires b + t(v2, S2) - V2 < 8AV. Constraint (T) implies that t(v2, S2) > 8AV, which implies
that there is always slack in IC+ whenever V2 > b.
1 The assumption that the two projects are identically distributed is made for notational simplicity only.
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FIGURE 1

IMPLEMENTATION REGION FOR A SINGLE IMPLICIT CONTRACT

V Firm implements project (/=1)

ab

b-6A V *(s1, v1)

"T1v --as

projects, the optimal static contract will be the same regardless of the number of projects the firm
undertakes.
There is an important difference when the firm engages in multiple implicit contracts-the
firm can condition its implementation decision on the returns generated by both projects (i.e.,
II(vI, sI, V2, S2) :& I*(vi, sI) in some instances). The firm may want to do this in circumstances
when an incentive-compatibility constraint is binding in the single implicit contract case (program
PI) as described above and depicted in Figure 1.
We first need to write down the optimization problem for the firm in the multiple implicit
contract case (program P2). The agents' optimal effort choice (pM(bi, Ii, ti, a)) and the expected
revenue for the firm conditional on the agents' generating a project (Rm(bi, Ii, ti)) are defined
analogously to the single implicit contract case.12

2lM(at, 0) = max pM(bl, II, tI, at)RM(bl, II, ti, 0) + pM(b2, 12, t2, a)RM(b2, 12, t2, 0)
b, J1, t1, b2, I2, t2
(P2)
subject to

II2[bi +t -vi +b2 +t2-v2] <_ (AVI + AV2) (IC++)


I, (I -I2)[b, + t -vi + b2 + t2-v2] ?< (A VI + A V2) (IC)+-)
(1 - II)I2[b1 + t1 - v, + b2 + t2 - V2] < 8(AV1 + AV2) (IC-+)
(1Ii)( - I2)[b, + ti - v + b2 + t2 - V2 < 8(A VI + A V2) (IC--)
t1 + t2 < 8(AV1 + AV2) (T)
tI ?0, t2> 0 (F)

where

AV Vi (81C(a, I b1, tI, II) - 7rjQ)).

We can readily verify that constraints (IC++), (IC+-), (IC-+), (IC--), (T), and (F) are the two
project analogs to the incentive-compatibility constraints in the single implicit contract (program
(PI)).
The central idea is that, even though (IC+) binds for project sI, vi in the single implicit
contract case, (IC++) can be satisfied in the multiple implicit contracts case, provided project

12 Note that the results from this section are general and do not depend on the previous assumption that v and s are
independently distributed. Consequently, for the remainder of the article I will suppress the notation on 6.
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MURDOCK / 663

S2, v2 is sufficiently attractive to the firm.13 This will allow the firm to implement
relaxing a binding constraint in program (P1) and therefore increasing the firm's profits.
Define b*, I*, t* as the solution to program (P1). We can define the multiple implicit contract
with b1 = b2= b* and tl(v, s) = t2(v, s) = t*(v, s). I will now demonstrate how the firm can
implement project si, vi if project S2, V2 is sufficiently attractive. By parallel logic to that described
in footnotes 12 and 13, tl(vl, sl) = 0 and t2(v2, S2) < 3AV, so constraint (IC"+) will be satisfied
and the firm can implement both projects if

V2-b*>b*-v,-8AV. (6)

The left-hand side of (6) is the slack in constraint (IC') from the second (highly profitable)
project, while the right-hand side is the amount by which the first project fails to satisfy constraint
(IC'). Thus joint enforcement of the implicit contracts allows the firm to implement project si, v1,
relaxing a binding constraint in program (PI) and thereby increasing the firm's profits. This result
is summarized in Proposition 5.

Proposition 5. Joint enforcement of multiple implicit contracts can create value over the base
case of the same number of contracts each being separately enforced.

Bernheim and Whinston (1990) studied a similar problem in the context of multimarket
contact between firms. One of their results was an irrelevance result-that there needed to be
differences between the markets in which the two parties interacted in order for there to be slack in
one constraint simultaneous with a binding constraint in another market. This result complements
that one. Even though there is no ex ante difference between the two projects because the projects
are drawn from the same distribution, there are differences ex post depending on which projects
are generated by each agent's effort.
Of course, the joint enforcement of multiple implicit contracts is only valuable when an
incentive-compatibility constraint is binding, so it is reasonable to determine conditions under
which we would expect a constraint to bind. When agents are purely extrinsically motivated (i.e.,
a = 0), there will be no binding constraint (provided the firm is sufficiently farsighted). To see
this, consider the first-best contract for extrinsically motivated agents-the firm will implement
all projects with positive financial return and no projects with negative financial return. The firm
will only have incentive to defect from the implicit contract when v < b, and the firm's maximum
incentive to defect occurs when v = 0. Thus, if the firm can credibly pay a bonus payment of
b when v = 0, the first best can be implemented in an implicit contract when agents are purely
extrinsically motivated (i.e., a = 0). So for constraint (IC') to be satisfied for the single implicit
contract, we must have

b< K (7ric(O) - 7r,(0)). (7)


- 1 -8

Constraint (IC') will be strictly satisfied whenever 8 > a = b/[b + iric(O


consequence, no value is created by joint enforcement of multiple implicit contract
are extrinsically motivated and the firm is sufficiently farsighted.
There is a different result when agents are intrinsically motivated. To see th
profits earned by the firm, assuming the firm could implement the first-best
The firm can never implement an implicit contract that yields it higher profits t
outcome. This places an upper bound on the profit at stake from maintaining the i
If it is the case that the financial return to a project is sufficiently negative, then

13 Note that constraint (IC++) is the critical one for this exercise because it is the one that nee
the firm can credibly implement both projects (i.e., I, 12 = 1).
14 Note that A V1 = A V2 = A V in the optimal implicit contract because of the symmetry o
decisions by the agents.

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664 / THE RAND JOURNAL OF ECONOMICS

(v) is greater than the incremental profits and the firm can never credibly implemen

8
V < - _(7rist(Q) - 7rs(U)). (8)

This means that some projects with positive surplus (where v +as > 0 because s is large) can-
not be implemented and so an implicit contract cannot implement all positive surplus projects when
agents are intrinsically motivated. This implies that there are conditions under which constraint
(IC+) is binding in the single implicit contract and so value will be created by joint enforcement
of implicit contracts. This is summarized in Proposition 6.

Proposition 6. Joint enforcement of implicit contracts can create value when agents are intrin-
sically motivated, but it creates no value when agents are extrinsically motivated and the firm is
sufficiently farsighted.

This highlights an important distinction between intrinsic and extrinsic motivation-non-


contractibilities are inherently more severe when agents are intrinsically motivated. This arises
because the agent's intrinsic motivation creates another dimension over which the firm and the
agent can exchange in trade. The gains in trade facilitate value creation through the implicit
contract, but they also create circumstances in which the interests of the firm and the agent
diverge significantly (i.e., projects with negative financial return but positive intrinsic return).
To maximize these gains from trade due to intrinsic motivation, it is sometimes efficient for
the firm to condition its decision on whether to implement a particular project on the profitability of
other projects generated elsewhere in the firm. In contrast, when agents are extrinsically motivated,
these gains from trade do not exist and the firm has no incentive to condition its decision on the
outcome of other projects.

7. Correlated returns

* So far in the analysis, I have either made no assumption about the correlation structure
between financial and intrinsic returns or assumed that they are independent. I turn now to examine
the impact on the optimal static and implicit contract when the two kinds of returns are correlated.
This distinction is relevant because, depending on the nature of the investment problem facing
the firm, the underlying correlation structure should differ. For example, a start-up firm developing
state-of-the-art technology may be able to attract engineers who gain significant intrinsic returns
from developing cutting-edge "cool" technologies. In the early phases of the industry life cycle,
then, there may be very high correlation between the two returns as those firms with the most
advanced technology also reap the greatest financial returns. As the technology matures, however,
more mundane activities like investments to increase reliability and to reduce operating costs
become more valuable relative to investments that push forward the state of the art. Thus over
time we would expect the correlation between financial returns and intrinsic returns to decline.
The deterioration of Apple Computer, Inc. may be partially explained by its engineers' emphasis
on advancing its technical capabilities and the company's unwillingness to make more plebeian
investments (such as converting the operating system to run on Intel machines) that would have
enhanced long-run returns.
Thus the firm's choice of product market strategy should affect the correlation structure of the
financial and intrinsic returns. If we find that the relative profitability of static and implicit contracts
differs when returns are correlated or independent, then we might expect to see an interaction
between a firm's product market strategy and its human resources strategy. That is, we might
observe that a product market strategy that generates correlated returns may be more commonly
paired with a human resource strategy emphasizing static contracts, and a product market strategy
generating more independently distributed returns may be more commonly paired with implicit
contracts.
I want to consider two different product market strategies-one that generates intrinsic
rewards that are correlated with financial returns and one that generates intrinsic rewards that
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MURDOCK / 665

are distributed independently of financial returns. It is critical to set up a "fair" comparison, so


we want the total potential surplus of the two strategies to be identical. This requires that the
expected intrinsic reward given that a project has a positive financial return is identical across the
two strategies (i.e., Ec(s I v > 0) = E1(s I v > 0)).
For the product market strategy that generates correlated returns, I will assume for simplicity
that every project generated by the agent has s = Xv, with X > 0. The expected intrinsic return is
then

EC(s (Iv| ?- 0)) 1-G(0)


= II GO Jo0
vdG(v).
For the product market strategy with independent returns, I similarly require that

X 00
E'(s I v > 0) = I G(O) vdG(v).

I describe this as a fair comparison because if the firm could commit to an implementation
rule that it will execute all v > 0 projects, then the effort level of the agent and the profit to the
firm would be identical across the two product market strategies.
The static contract under correlated returns is one where the firm will pay a fixed bonus b'
to the agent should the firm implement her project. The agent will then choose her effort level pc
to maximize her utility, giving rise to the following first-order condition:

C'(pI ) = [bc + aEc(s I v > bc)] (1 - G(bc)). (9)


The firm will choose bc to maximize its profits

7r(a) = max pc j (v- b)dG(v).


b b

It turns out that for any g


independent (i.e., 7rc(a
returns to the agent is
This can be seen by inspection of Figure 2. This results in the agent having higher effort incentives
when returns are correlated. Thus the firm gets the same per-project financial return and more
projects generated when returns are correlated under static contracts. This is summarized in
Proposition 7 and proved in the Appendix.

Proposition 7. When the firm faces equally attractive environments (i.e., Ec(s I v > 0) = E1(s
v > 0)), it can earn higher profits with a static contract when financial and intrinsic returns are
correlated than when returns are independently distributed (i.e., 7rc(a) > ?r(a)).

This result arises because when returns are independent, some projects with high intrinsic
returns are not implemented because their financial returns are too low. With perfectly correlated
returns, all very-high-intrinsic-return projects are implemented because their financial returns
are also higher. If the assumption of perfect correlation were relaxed, it should be clear that the
proposition would still hold because a higher percentage of projects that are valuable to the agent
would be implemented.
In contrast, when the firm is engaged in an implicit contract, the relative profitability of the two
product market strategies reverses. For simplicity, assume that the firm is sufficiently farsighted
that it can credibly implement the first-best implicit contract when returns are correlated.16 Then

15 It is obvious that the firm will never implement a project with v < 0 because s < 0.
16 The result generalizes whenever the firm can credibly commit to some kind of implicit contract. This assumption
is made for expositional simplicity.

(D RAND 2002.

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666 / THE RAND JOURNAL OF ECONOMICS

FIGURE 2

EXPECTED INTRINSIC RETURNS FOR CORRELATED AND DEPENDENT DISTRIBUTIONS

E'(slIV)

Ic~ V)s V

EC(sIO<v<b) E'(sIOv<b)

the objective of the implicit contract is to allow the firm to commit to implementing all projects
with positive financial return because all these projects also have positive surplus. With inde-
pendent returns, the firm could also implement all projects with positive financial return. Given
the assumption that the two environments are equivalent (i.e., EC(s I v > 0) = E'(s I v > 0)),
then this contract would generate the same profit for the firm as the maximum profit under an
implicit contract with correlated returns. Yet the firm can improve on this outcome when returns
are independent. In particular, the firm can choose not to implement projects that neither the firm
nor the agent desires to have implemented (i.e., v < b and v + as < 0). This will increase both
the effort level of the agent and the per-project profit for the firm. This result is summarized in
Proposition 8 and proved in the Appendix.

Proposition 8. When the firm faces equally attractive environments (i.e., EC(s I v > 0) = Ei (s |
v > 0)), it can earn higher profits with an implicit contract when financial and intrinsic returns
are independently distributed than when returns are correlated (i.e., -irc(a) > 7 a

To understand the implication of Proposition 8, it is important to note that implicit contracts


have the most value when the static incentives of the firm and agent are in disagreement. For
example, an implicit contract creates value when the firm commits to implement a negative-NPV
project that brings a large positive intrinsic reward to the agent. When the financial and intrinsic
returns are correlated, this rarely happens, whereas when they are independently distributed, it
will happen more frequently. This is the rationale behind Proposition 8.
From Propositions 7 and 8, we can draw the conclusion that there are greater gains to the
firm when it implements an implicit contract in environments where returns are independently
distributed than when returns are highly correlated, because the incremental returns from writing
implicit contracts are higher with independence. That is, Jr'c(a) - 7r((x) > Jrcc(a) - 7r((x).
While it is the case that firm profits are higher under implicit versus static contracts, there
may be a fixed cost associated with either initiating or maintaining the implicit contract that
the firm will not have to bear under static contracts. It should be clear that the information
requirements needed to implement static contracts are lower. The agent develops a project and
the firm implements it only if it has a positive private return. The firm never needs to learn the
intrinsic return to the agent because its decision rule is independent of that. In contrast, under
implicit contracts, the firm needs to know the intrinsic return of the agent (at least in some states of
the world) because there exists a range of financial returns under which the firm's implementation
decision is contingent upon the intrinsic return to the agent. If this fixed cost is high enough (i.e.,
if zr c o) - zf (,) < FC < r C(a) - 7r((a)), it will be optimal for the firm to implement an
implicit contract when returns are independent and to implement a static contract when returns
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MURDOCK / 667

are correlated. Thus the firm's optimal choice of human resources strategy (static versus implicit
contracts) may depend on its product market strategy (which affects the correlation of financial
and intrinsic returns).

8. Conclusion
* This article makes four primary contributions. First, it develops the principal-agent literature
by including intrinsic motivation in the agent's incentive structure in a nontrivial way. In particular,
I examine the role of intrinsic motivation in an environment where it has no direct effect on the
disutility of effort (i.e., where the unconditional expected intrinsic benefits are zero). Intrinsic
motivation affects optimal incentive contracts only to the extent to which the firm alters its
investment decisions in response to the intrinsic motivation of its workforce.
Second, the article proves that intrinsic motivation and implicit contracts are complements.
In particular, the gains to the firm from establishing an implicit contract are increasing in the
degree to which its agents are intrinsically motivated. This result derives from the underlying
source of value to the firm from hiring workers with this kind of motivation. When workers are
intrinsically motivated, there are "gains from trade" that arise when the firm implements a project
that has negative financial return but generates large intrinsic returns to the agent. The trade is
mediated intertemporally. When the firm commits to implement some negative-expected-value
projects due to their high private benefits to the agent, its expected profits from each generated
project is lower. The agent, however, works harder, and this increased effort generates more
positive-expected-profit projects for the firm. This increased rate of project generation more than
compensates for the lower profit per project.
Third, the article shows that joint enforcement of multiple implicit contracts is more likely
to arise when agents are intrinsically motivated. Joint enforcement is only necessary when the
firm's incentive-compatibility constraint binds, preventing it from implementing efficient projects.
When agents are extrinsically motivated, the incentive-compatibility constraint will not bind for
farsighted firms. In contrast, there are always projects that the firm cannot credibly implement
when agents are intrinsically motivated.
Fourth, the article shows that characteristics of the product market strategy of the firm affects
the relative payoff to static and implicit contracts. The firm's choice of product market strategy will
affect the degree of correlation between the financial and intrinsic returns of the firm's projects.
Returns from static contracts are higher when returns are positively correlated than when they
are independent. Under a static contract, the firm can only commit to implement positive-profit
projects. With correlated returns, positive-profit projects also have positive intrinsic benefits. In
contrast, returns from implicit contracts are higher when returns are independent. Recall that the
benefits of implicit contracts depend on the gains from trade that occur when the firm commits to
implement negative-profit but positive-intrinsic-return projects. With independent returns, there
is greater weight on these outcomes.
Future research may profitably explore additional implications of intrinsic motivation on
agency relations. In particular, because of the inherent difficulties of contracting on an individual's
utility function, it is likely that issues of contractual incompleteness will be more severe when
agents are intrinsically motivated. In a first-best world, this contractual incompleteness is likely
to create inefficiency. Many agency relationships, however, are characterized by second-best
outcomes. Future research could explore possible mechanisms by which a principal might be able
to implement a superior second-best outcome by hiring agents with intrinsic motivation.

Appendix

* Proofs of Propositions 2, 4, 7, and 8 follow.

Proof of Proposition 2. In an optimal implicit contract, the firm will choose to implement projects to ensure that the
conditional expected intrinsic return is strictly greater than the unconditional return (i.e., E(s | I = 1) > E(s)).
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668 / THE RAND JOURNAL OF ECONOMICS

Suppose not. Then there exists an optimal implicit contract (defined by b, I, i) where E(s I I =
x(v) by

f I(v, s)dH(s) = 1 -H(x(v))


-00

We can now define a new implementation criterion, I'(v, s), that implements the exact same fraction of projects as I(v, s)
for every v. That is, I'(v, s) = 1 for all s > x(v) and 0 otherwise.
Next we need to construct the transfer payment function. Define

t1(v) f I(v, s)?(v, s)dH(s)


-00

and

to(v) [I - I(v, s)]?(v, s)dH(s).


-00

The transfer payment function

t'(v, s) = I'(v, s)t1(v) + [1 - I'(v, s)]tO(v)

will satisfy the incentive-compatibility constraints (T) and (F) by construction. Similarly, (IC+) and (IC-) will be satisfied
if b' = b.
The alternative implicit contract (b', I', t') has been constructed so that it is feasible and such that the financial
return to both the firm and agent, conditional on a project's being generated, is equivalent to that from (b, I, t). That is,
R(b', I', t') = R(b, I, t) and y(b', I', t') = y(b, I, i). However, E(s I) < E(s) < E(s I'). By inspection of (6),
we can verify that pIC(b, I, t, a) < pic(b', I', t', a). This implies that z c(b, I, ta) < 7ric(b', I', t', at), which is a
contradiction. Q.E.D.

Lemma Al. Define si, S2 by H(sI, 01) = H(s2, 02). Then 01 > 02 implies that

J sdH(s, 01) > f sdH(s 02).

The inequality is strict provided that sI /2

S1, S2 are defined such that the probability that s > sI in a draw from distribution H(
probability that s > S2 in a draw from distribution H(s, 02). The claim is that a mean-preserving spread shifts weight out
to the tail such that the right-censored expectation is increasing.
To prove the claim, we need to show that

A f sdH(s, 01) - sdH(s, 02) > 0

Integrating by parts yields

A = s2H(s2, 02)- siH(sI, 01) + f sdH(s, 02)- sdH(s, 01).

We know that H(sI, 01) = H(s2, 02) by the definition of sI, S2, so

A = (S2- sl)H(s2, 02) + f sdH(s, 02) - sdH(s, 01).

There are two possibilities: either sI > S or sI < S2-

Case 1. SI > S2, then

A = f [H(s, 02) - H(s, 0I)]ds + f [H(s, 02) - H(s, 0I)]ds > 0.


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MURDOCK / 669

The first term is nonnegative by the definition of 01 as a mean-preserving spread


because H(s, 02) > H(s2, 02) for all s E [S2, S1 ] whenever SI > S2 because H(s, 02) is nondecreasing in s.

Case 2. sI < 52, then

{00 rS2
A = f [H(s, 02)- H(s, 0i)]ds + f [H(s2, 02)- H(s, 02)]ds > 0.

The first term is again nonnegative by the definition of 01 as a mean-preserving spread. The second term is nonnegative
because H(s2, 02) > H(s, 02) for all s E [SI, S2] whenever sI < S2 because H(s, 02) is nondecreasing in s. Q.E.D.

Proof of Proposition 4. Implicit contracts become more valuable to the firm when distribution of intrinsic returns expe-
riences a mean-preserving spread (i.e., (d/d0)[rIc(at, 0) - rs(a)] > 0).
Because the profitability of the static contract is independent of 0, we simply need to show that (d/d0)7rIC(a, 0) > 0,
orthat 7ric(a, Oi) > 7rzc(a, 02) for01 > 02.
Define b2, 12, t2 as the optimal implicit contract when 0 = 02. The task is to define a bl, II, t1 such that

7rsc(bi, II, ti, ot, 01 ) > 7rzc(b2, I2, t2, Ul, 02)-

We know from the proof of Proposition 2 that there exists an s2(v) such that 12(v, s) = I for s > S2(v) and 0
otherwise. Define s I(v) by H(si (v), 01 ) = H(s2(v), 02) and define I I(v, s) = 1 for s > si (v) and 0 otherwise. This is
the key idea of the proof. Conditional on v, the firm has the same probability of implementing a project under implicit
contract bi, II, t1 when 0 = 01 as under implicit contract b2, 12, t2 when 0 = 02. This will allow us to create a contract
that has the same financial returns but offers increased intrinsic returns due to the mean-preserving spread.
Next we construct bl, t1 such that the financial returns to both the firm and the agent are the same under both implicit
contracts. Define b, = b2 and t 1, tio by

00 f00
J tIIdH(s, 01) = t2(s, v)dH(s, 02)
s1(V) Js2 (v

and

JsI (V) jS2 v)


tlodH(s, = 1 t2(s, v)dH(s, 02)-
-o0 -00

Then t1(s, v) = t11 for s > s1(v) and t1(s, v) = t1o for s < s1(v). By construction, we have y(bl, II, t1, 01) =
y(b2, 12, t2, 02) and R(bl, II, t1, 01) = R(b2, 12, t2, 02)-
Given that the per-project financial returns are equal (i.e., R(bl, II, t1, 01) = R(b2, 12, t2, 02)), we simply need to
show that pic(bl, II, t1, a, 01) = pIc(b2, 12, t2, a, 02) to prove that 7ric(bi, II, t1, a, 01) = 7rwc(b2, 12, t2, a, 02)-
From (5),

c' (pic(b, I, t, a, 0)) = y(b, I, t, 0) + a f I(v, s)sdG(v)dH(s, 0),

and we have already shown that y(bl, II, ti, 01) = y(b2, 12, t2, 02), so to prove that

iric(bl, II, t1, a, 01) = Trzc(b2, 12, t2, a, 02)

we need to show that

ff | 1(v, s)sdG(v)dH(s, 01) > ff 12(v, s)sdG(v)dH(s, 02)-

This is equivalent to

C00 F00 0OC F00


I sdH(s, 01) dG(v) > | 0 sdH(s, 02) dG(v)
J-00 Jsj(v) J -00 U s2(v)

by how II, 12, SI, S2 were defined.


This last condition is satisfied by Lemma Al (which applie
a mean-preserving spread).
To summarize the proof, for OI we constructed an implicit contract bl, II, t, such that the per-project financial
returns were unchanged (i.e., y(bl, II, t1, 01) = y(b2, 12, t2, 02) and R(bl, II, tI, 01) = R(b2, 12, t2, 02)). Under the

17 f100 sd H(s, 0 -) = f'0 - sd H(s, 02) and f'00 H(s, 01 )ds > f-1o H(s, 02)d s jointly imply that fo?? H(s, 01 )ds >
f~x?? H(s, 02)ds. This can be verified by integration by parts.
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670 / THE RAND JOURNAL OF ECONOMICS

mean-preserving spread, however, the probability distribution shifted to the right, so even though the financi
unchanged, the intrinsic returns to the agent increased. This increased the agent's effort level (i.e., pIc(
pIC(b2, I2, t2, a, 02)), so the profits to the firm increased.

Lemma A2. Assuming that EC(s v >0) = E1(s I v >0), thenV b >0, EC(s I v > b)> E(s I v > b).

Proof. E'(s I v > b) = E1(s I v > 0) because s is distributed independently of v. Thus, we need to show that
EC(s I v > b) > EC(s I v > b) to complete the proof.

dEC;sgIb> 0f vd;v g(b) 00


db EX(s ) v > b) = vdG(v)-b( -G(b))] Gb (2 V - b)dG(v) > 0.
db [I [-G(b)2 b[--I - 0] b)

Thus because Ei (s I v > b) is increasing in b,

EC(s I v > b) > EC(s I v > 0) = E'(s I v > 0) = E'(s I v > b). Q.E.D.
Proof of Proposition 7. When the firm faces equally attractive environments, it can earn higher profits with a static contract
when financial and intrinsic returns are correlated than when returns are independently distributed (i.e., 7r,(0t) > 7r'(a0)).
Define b* as the explicit incentive that maximizes firm profits under the static contract when returns are independent.
Then rsi(a) = rsi(a I b*) = ,ri(b*, a) fo vdG(v). Now we know that 7rf(s I b*) = ,rC(b*, a)f0? vdG(v), so the only
difference between firm profits when returns are correlated arises due to changes in the agent's effort incentives.
From inspection of (3) and (9), we have

c' (p'(b*, a)) = (b* + aE1(s | v > b*)) [1- G)b*)] (3)

c' (pc(b*, a)) = (b* + aEC(s I v > b*)) [1-G)b*)]. (9)

Lemma A2 proves that EC(s I v > b*) > E1(s I v > b*), so this implies that pc(b
have that 7rsc(a I b*) > 7si(a I b*). Q.E.D.

Proof of Proposition 8. When the firm faces equally attractive environments (i.e., ,r1C(bc, IC, tc, a) = ,rc(bc, IC, tc, a))
it can earn higher profits with an implicit contract when financial and intrinsic returns are independently distributed than
when returns are correlated (i.e., 72crc(a) > 7rlc(00).
Provided the firm is sufficiently farsighted, the optimal implicit contract when returns are correlated will have the
firm implement all projects with positive financial return. Ic(v, s) = 1 for all v > 0 and Ic(v, s) = 0 otherwise. This can
be implemented with a bonus payment bc and no voluntary transfer payments (i.e., tC(v, s) = 0).
When returns are independent, it is straightforward to verify that the firm can implement the same contract terms and
achieve the same level of profits (i.e., ,rc(bc, IC, tc, a) = ,ic(bc, IC, tc, a). This arises directly from our assumption
that the environments are equally attractive (i.e., Ei(s I v > b) = E (s I v > 0)), so the expected intrinsic return is the
same for both independent and correlated returns when all positive-financial-return projects are implemented.
Define li(v, s) = 0 if 0 < v < bc and v + as < 0 and li(v, s) = Ic(v, s) otherwise. Under this alternative implicit
contract, the firm will implement all projects specified by Ic(v, s) except those for which both the firm and the agent yield
negative returns.
When the agent is intrinsically motivated, (i.e., a > 0), we can verify from the first-order condition of the agent that
P c(bc, li, tc, a)> pzc(bc, IC, tc, at). Similarly, li(v, s) has been defined such that RICc(bc, P, tc) > RZc(bc, JC tc).
Then,

2rc(a) = max pic(b, I, t, a)RcC(b, I, t)


b,I,t II
I. , C
> P c(bc ,1, tc, o)R'
> picc(bc, IC, tc, ot)RscC(bc, IC tc) = 7,c a Q. E. D.

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