Contracts and Moral Hazards
Perloff Chapter 20
Principal Agent Problem
• Contract with an individual who’s actions are not
observed.
• Individual may not act fully in your interests.
• Examples
– Shirking at work.
– Insurance.
• Principal contracts with the agent to take an
action which benefits the principal
Contracts and Efficiency
• Types of contract
– Fixed fee: independent of actions, states of nature or
outcome.
– Hire contract: either hourly or piece rate.
– Contingent: dependent on the state of nature.
• Type depends on what the principal can observe.
• Efficiency:
– In production requires sum of principal and agent’s
payoffs are maximised.
– In risk: Requires that least risk averse individual bears
the risk.
Efficient Contract in the Absence of
Risk
• Maximises joint profits.
• Incentive compatibility:
– The contract ensures that it is in the agents best
interests to take actions which maximise joint
profits.
  a   R  a   12  a 
p  24  0.5a
Agent’s marginal revenue,
$ per carving
(a) Agent’s Problem
24
12
e
MC
Demand
MR
0
12
72
24
a, Duck carvings per day
(b) Profits
Agent’s profit, $
Maximising
Joint Profit
and a Fixed
Fee Contract
E
π, Joint profit
24
0
E*
12
π – 48,
Agent’s profit
24
a, Duck carvings per day
Hire Contract
• Principal allows agent to retain $12 for each
carving sold.
– Agent has to pay $12 to purchase each duck.
– Therefore indifferent between participating or not.
– With supervision, instructed to sell the profit
maximising q he gets zero profit and fails to join.
• Principal pays $14.
– Agent tries to maximise sales not profits.
– If agent controls sales their profit is:
  a   R  a   14  a 
• Contract is not incentive compatible
• Contingent contract
(dependent on
revenue)
• Agent gets ¾ of the
revenue.
• Not Incentive
compatible
24
18
12
e*
e
MC
MR
3
MR* = – MR
4
0
8
12
24
a, Duck carvings per day
(b) Profits
Agent’s profit, $
Revenue sharing
Agent’s marginal revenue,
$ per carving
(a) Agent’s Problem
E
72
64
π, Joint profit
E*
24
0
8
3
– R – 12a,
4
Agent’s profit
12
16
24
a, Duck carvings per day
Agent’s profit, $
Profit Sharing
72
π, Joint profit
1
– π, Agent’s profit
3
24
0
12
24
a, Duck carvings per day
Asymmetric Information
• Principal is not able to fully monitor sales.
• Fixed Fee
– No opportunity to exploit.
• Hire contract
– Agent may under report sales in order to retain more than just $12.
– Unless all profit is retained, still incentive incompatible.
• Revenue sharing.
– Agent can retain larger share of revenues than specified.
– If all revenue is retained, it becomes incentive compatible, the
agent is the firm.
• Profit sharing
– Over-reporting cost, under reporting revenue leads to inefficiency.
Trade off between efficiency in
production and risk bearing
• Lawyer (agent) working for client (principal).
– Whether payoff occurs depends on state of nature (jury).
– Size of payoff depends on lawyers actions.
• Fixed fee.
– Agent has little incentive to work, therefore production inefficiency.
– Agent bears all the risk, they are likely to be risk averse.
• Client gets a fixed payment
– Agent works to the point where MC=MB.
– Risk is all borne by the principal.
– Client may not agree to this type of contract because of moral hazard.
How do they know they are paid enough.
• Hourly fee
– Moral Hazard problem, agent lies about the hours worked.
– Risk all borne by the principal.
• Contingent
– Like the revenue sharing contract this encourages sub optimal effort.
– Risk is shared in proportion to the sharing of the payout.
Payments linked to production or
profit
•
•
•
•
Employer:employee contracts
Hourly payments or fixed salary.
Neither rewards actual effort.
Two alternatives:
– Payment linked to individual output.
– Payment linked to output or profit.
• Both require monitoring.
Payment by piece rate
• Payment directly linked to output.
• Difficulties:
– Measuring output.
– They can encourage the wrong sort of
behaviour.
– Persuading workers to accept them.
Contingent contract
• Some workers, managers, have productivity
which is difficult to quantify.
• Lump sum bonus.
• Stock option.
– Option to buy stock at a specified price.
– Act as golden handcuffs.
Monitoring
• An alternative to piece rate or contingent contract
in avoiding moral hazard.
• Intensive monitoring eliminates the problem.
• May be costly and/or counter-productive.
– Lower morale.
– Workers in remote locations (sales force).
• Methods to reduce the costs of monitoring.
– Bonding
– Efficiency wage.
Bonding
• Agent provides a bond which is forfeited if they
fail to perform.
– A bond to prevent shirking.
– Raises the cost of losing job.
– The higher the value of the bond the less frequently an
employee needs to be monitored.
• Problems with the bond.
– The possibility of the principal making is a disincentive
to the agent.
– May act as a barrier to entry.
Alternatives to bonding
• Bonds act by increasing the cost of being fired.
• Deferred payments.
– Low wage initially.
– Over time shirkers a fired, those that remain see wages
increase.
• Efficiency wage.
– If an employee can immediately work elsewhere and
earn the same wage, they lose nothing.
– Pay a higher (efficiency) wage than would otherwise be
justified.
– Problem is all firms raise the wage and unemployment
results.
Contract choice
• Firms may offer a choice of contracts as a
means of eliminating moral hazard.
• Contracts act as a screening mechanism.
• Example:
– Contingent contract: No salary plus 30% of
sales.
– Fixed fee: $25000
Example of contract choice