In his discussion of the determination of wages, Adam Smith (1776, bk. 1, chap. 7) recognized the contractual nature of the relationship between the masters and the workers. He asserted the conflicting interests of those two players and recognized that the bargaining power was not evenly distributed between them; the masters generally had all the bargaining power. In the modern language of the theory of incentives, the masters are principals and the workers, their agents:
What are the common wages of labour, depends everywhere upon the contract usually made between those two parties, whose interests are not the same. The workmen desire to get as much, the masters to give as little as possible.
—Smith (1776, bk. 1, chap. 7, p. 66)
Smith also stressed one of the basic constraints that we model later on, the agent’s participation constraint, which limits what the principal can ask from the agent:
A man must always live by his work, and his wages must at least be sufficient to maintain him.
—Smith (1776, p. 67)
Smith did not have a vision of economic actors as long-run maximizers of utility. He worried about the consequences of high-power incentives for short-run maximizers:
Workmen . . . when they are liberally paid by the piece, are very apt to overwork themselves, and to ruin their health and constitution in a few years.
—Smith (1776, bk. 1, chap. 8, p. 81)
He stressed the lack of appropriate incentives for slaves:
[T]he work done by slaves, though it appears to cost only their mainte- nance, is in the end the dearest of any. A person who can acquire no property, can have no other interest but to eat as much, and to labour as little as possible.
—Smith (1776, bk. 1, chap. 8, p. 365)
To explain the survivance of such highly inefficient contracts, Adam Smith also appealed to noneconomic motives:
The pride of man makes him love to domineer, and nothing mortifies him so much as to be obliged to condescend to persuade his inferiors.
—Smith (1776, bk. 1, chap. 8, p. 365)
Smith’s most precise and famous discussion of incentives appeared in book 3, chapter 2, when he wanted to explain the discouragement of agriculture in Europe after the fall of the Roman Empire. He described the status of metayers (known as coloni partarii in ancient times and as steel-bow tenants in Scotland):
The proprietor furnished them with the seed, cattle and instruments of husbandry. The produce was divided equally between the proprietor and the farmer.
—Smith (1776, bk. 3, chap. 2, p. 366)
However, Smith did not conclude that metayers would not exert the appropri- ate level of effort to maximize social value, as modern incentive theory would claim:
Such tenants, being free men, are capable of acquiring property, and having a certain proportion of the produce of the land, they have a plain interest that the whole produce would be as great as possible, in order that their own proportion may be so.
—Smith (1776, bk. 3, chap. 2, p. 366)
At several places in this volume, we see the fundamental trade-off between incentives and the distribution of the gains from trade. Clearly Smith was not aware of this trade-off. Rather, he saw the most serious incentive problems in the absence of tenants’ investment in the land, and in the unobservable misuse of husbandry instruments provided by the proprietor.
It could never, however, be the interest even of this last species of culti- vators (the metayers) to lay out, in the further improvement of the land, any part of the little stock they might save from their own share of the produce, because the lord, who laid out nothing, was to get one-half of whatever it produced. . . . It might be the interest of metayer to make the land produce as much as could be brought out of it by means of the stock furnished by the proprietor; but it could never be in his interest to mix any part of his own with it. In France . . . the proprietors complain that their metayers take every opportunity of employing the master’s cat- tle rather in carriage than in cultivation; because in the one case they get the whole profits for themselves, in the other they share them with their landlords.
—Smith (1776, bk. 3, chap. 2, p. 367)
Note the ambiguous might, which shows that Smith probably envisioned under-effort but that he considered it secondary compared to the under-investment effect. However, the alternative use of cattle is a typical example of what we will call a hidden action problem or a moral hazard problem.
Smith’s criticism of sharecropping has been the point of departure of a large literature in agricultural economics, history of thought, and economic theory trying to understand the characteristics of sharecropping contracts. Following Smith, and until Johnson (1950), economists considered sharecropping to be a “practice which is hurtful to the whole society,” an unexplained failure of the invisible hand that should be either discouraged by taxation or improved by appropriate sharing of variable factors.3 A better understanding of the phenomenon was only achieved when the economists reconsidered the problem in the context of the principal- agent theory.
Source: Laffont Jean-Jacques, Martimort David (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.