ABSTRACT: Optimal agency contracts pay the lowest wage necessary to induce profit‐maximizing effort. Employees could view such contracts as violating reciprocity because, relative to more reciprocal contracts, they offer a lower wage in exchange for higher effort. Consequently, the profit‐maximizing effectiveness of optimal contracts could be impaired if employees reject them or reduce their effort. We use experimental labor markets to examine (1) how employees respond to an optimal versus a suboptimal reciprocity‐based contract when each contract is the only contract available, (2) how employees respond to these contracts when firms choose which one to offer, (3) whether the firms' contract offers depend on employees' reactions to those offers, and (4) how employees and firms react to a hybrid contract that incorporates features of both contracts. We find that the optimal contract is less effective than agency analysis predicts, the reciprocity‐based contract can be equally effective, and the hybrid contract dominates a market in which all three contracts are available. Implications of these results are discussed.

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