The Effect of Random Shocks on Reciprocal Behavior in Dynamic Principal-Agent Settings

Previous work has shown that unobservable random shocks on output have a detrimental effect on efficiency in short-term (‘static’) employment relationships. Given the prevalence of long-term (‘dynamic’) relationships in firms, we investigate whether the impact of shocks is similarly pronounced in gift-exchange relationships where the same principal-agent pair interacts repeatedly. In dynamic relationships, shocks have a significantly less pronounced negative effect on efficiency than in static relationships. In an attempt to identify the drivers for our results we find that the combination of a repeated-game effect (current misbehavior can be punished in future periods) and a noise-canceling effect (part of the noise cancels out in the long run) is required to avoid the detrimental effects of unobservable random shocks on efficiency.