Self Selection and market power in risk sharing contracts

• We investigate existence of self-selection by risk aversion into labor contracts and its interaction with market power.
• Our results provide support for standard contract theory and for self-selection.
• Individuals on both sides of the market exploit market power when they have it.
• Self-Selection among workers occurs when participation constraints are binding.
• Characteristics of parties excluded from a contract are also important in determining terms.

Although the theory of optimal contracts and the principal agent model are now well established in the literature, empirical support for this theory has been mixed at best. We use economic experiments to test contract theory and assess the empirical relevance of two possible confounding factors that may explain why the theory has not received stronger empirical support. First, parameters of interest may be biased if agents self-select into projects with differing risk profiles based on risk preferences. Second, differing levels of market power on either side of the market could shift contract terms in ways contrary to theoretical predictions. In general, we find support for classical contract theory augmented to accommodate market power and self-selection based on risk preferences. We also find evidence for a third confound in the form of the characteristics of agents not party to the transaction affecting the terms of the contract.