Carrots versus sticks

While carrots and sticks create in principle identical marginal incentives, they are not randomly used in legal enforcement systems. This paper tries to draw a broader picture of their nonequivalence than previous contributions. It analyzes the fundamental characteristics of carrots and sticks and derives general rules on their optimal use. If a benevolent principal is fully informed about the agents’ effort costs, she will only use sticks, as they are not meant to be applied, thus minimizing transaction costs and risks. In addition, sticks cause less distributional distortions when the agents are sufficiently homogenous with respect to effort costs and benefits. However, these comparative advantages of sticks weaken as the complexity of the situation increases (the principal is less informed or agents are heterogeneous). Moreover, sticks are inherently more dangerous tools in the hands of non-benevolent principals since enforcement under carrots is always Pareto efficient while enforcement under sticks is not even necessarily Kaldor-Hicks efficient. Our analysis suggests that, as society becomes more complex (labor more specialized, preferences more heterogeneous, and decisions more decentralized), carrots will be used more frequently.