A Generalized Principal-Agent Model With Lying Costs

Lie-aversion and lying costs should be included in models because disclosing hidden information generalizes basic theory. The agent in our principal-agent model has an exogenous lying cost. If it is high enough, she can be offered a first-best contract. If not, a modified contract outperforms the classic contract. If her cost is private information, lying occurs in equilibrium. The generalized theory suggests that the widespread offering of incentive contracts may initiate a ‘vicious circle,’ if it communicates untrustworthiness and lowers lying costs. Furthermore, cultures of untruthfulness may contribute to economic decline, and appearing dishonest can be rent-enhancing.