Microeconomics: Theory and Applications
with Calculus
Fifth Edition
Chapter 19
Contracts and Moral
Hazards
The contracts of at least 33 major
league baseball players have
incentive clauses providing a bonus if
that player is named Most Valuable
Player in a Division Series.
Unfortunately, no such award is given
for a Division Series.
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Chapter 19 Outline
Challenge: Health Insurance
19.1 Principal-Agent Problem
19.2 Production Efficiency
19.3 Trade-Off Between Efficiency in Production and in
Risk Bearing
19.4 Monitoring to Reduce Moral Hazard
19.5 Contract Choice
19.6 Checks on Principals
Challenge Solution
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Challenge: Clawing Back Bonuses
• Background:
– A major cause of the 2007–2009 worldwide financial crisis was that managers and
other employees of banks, insurance companies, and other firms took excessive
risk.
– Bank managers three accepted lending practices out the window, rewarding
mortgage brokers for bringing in large numbers of new mortgages regardless of
risk. Brokers and their managers in response issued these risky mortgages.
– One response called for in the 2010 Dodd-Frank Consumer Protection Act was that
firms institute clawback provisions that would all firms to claw back or reclaim some
earlier bonus payments to managers if their past actions resulted in later losses.
• Questions:
– Solved Problem 19.1: Why did executives a these banks take extra risks that
resulted in major lost shareholder value?
– Challenge Solution: Does evaluating a manger’s performance over a longer period
using delayed compensation or clawback provisions lead to better management?
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19.1 Principal-Agent Problem
• In a principal-agent relationship a principal, such as an
employer, contracts with an agent, such as an employee,
to take some action that benefits the principal.
• Moral hazard in a principal-agent relationship is referred to
as a principal-agent problem or agency problem.
– Example: You pay someone by the hour to prepare
your tax return, but don’t know whether he/she worked
all the hours that were billed.
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19.1 Types of Contracts
• Three common types of contracts:
1.
Fixed-fee contracts
▪ Payment to the agent is independent of the agent’s actions, the state
of nature, or the outcome.
▪ Principal keeps the residual profit
2.
Hire contracts
▪ Payment to the agent depends on the agent’s actions as they are
observed by principal.
▪ Types include hourly rate and piece rate.
3.
Contingent contracts
▪ Payments to principal and agent depend on state of nature, which
may be unknown when contract is written.
▪ In a sharing contract, payoffs to each person are a fraction of total
profit.
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19.1 Efficiency
• Type of contract used depends on what the parties observe.
– Hire contract used if principal can easily monitor agent’s
actions.
– Contingent contract used if state of nature observed after
work is completed.
– Fixed-fee contract has no observation requirements.
• An efficient contract has provisions that ensure no party can
be made better off without harming the other party.
– Results in efficiency in production, where combined
payoffs are maximized.
– Results in efficiency in risk bearing, where person who
least minds risk bears more of the risk.
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Solved Problem 19.1: S&L Loans
• Setup: An S&L can make one of two types of loans
– Mortgages: 0.75 probability of earning $100million and 0.25 probability of earning
$80m
– Oil Speculators: 0.25 probability of earning $400million and 0.75 probability of
losing $160 million
– S&L manager receives 1% of S&L earnings, but protected from losses
• Questions
– Which decision would Bernie make?
– Which decision is best for S&L shareholders?
• Answers
利益冲突
– Bernie’s expected earnings:
▪ Mortgages  0.75  1,000,000    0.25  800,000   $950,000
▪ Oil speculators  0.25  4,000,000    0.75  0   $1,000,000
– Shareholders’ expected earnings:
▪ Mortgages  0.75  100,000,000    0.25  80,000,000   950,000  94.05million
▪ Oil speculators  0.25  400,000,000    0.75  160,000,000   1,000,000  21 million
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19.1 Application: Honest Cabbie?
• You arrive in a strange city and get in a cab. Will the driver take you to
your destination by the shortest route, or will you get ripped off?
• Experiment (Balafoutas et al., 2013)
– Two groups of native-speaking Greeks in Athens
▪ Moral Hazard: “I would like to get to Fill in the blank. Do you know
where it is? I am not from Athens.”
▪ Control: “Can I get a receipt at the end of the ride?” or “Can I
get a receipt at the end of the ride? I need it in order to have
my expenses reimbursed by my employer.”
• Results:
– Moral Hazard group: Overcharging in 36.5% of cases
– Control group: Overcharging in 19.5% of cases
– Fares averaged 17% higher in moral hazard group
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19.2 Production Efficiency
• The type of contract that an agent and principal use affects
production efficiency.
• To be efficient and maximize the joint profit of the agent
and principal, a contract needs two properties:
1. Contract must provide large enough payoff that agent
is willing to participate in the contract.
2. Contract must be incentive compatible in that it makes
the agent want to perform assigned tasks rather than
engage in opportunistic behavior.
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19.2 Production Efficiency Example (1 of 2)
• Buy-A-Duck store sells wooden duck carvings
– Paula is the principal (owner) and Arthur is the agent
(manager)
– Joint profit is a function of the number of ducks sold
(a), which is determined by Arthur’s actions and the
marginal cost of producing one more carving, m:
(a )  R(a )  ma
• How many ducks must Arthur sell to maximize join profit?
d(a ) dR(a )

m 0
da
da
• We can analyze this graphically with a few assumptions.
– FOC:
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19.2 Production Efficiency Example (2 of 2)
• Assuming m = 12 and
inverse demand is
p  24  12 a,
Arthur maximizes his
profit and joint profit at
a = 12.
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19.2 Full Information: Fixed-Fee Rental
Contract
• Assume both Paula and Arthur have full information about
Arthur’s actions and the effect on profit.
• In this situation, are there incentive-compatible fixed-fee
contracts that do not require monitoring and supervision?
– Arthur earns a residual profit; profit less fixed rent he
pays Paula.
– FOC is unchanged, so profit is still maximized when
Arthur sells 12 ducks.
– This occurs because Arthur gets entire marginal profit
from selling one more duck.
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19.2 Full Information: Hire Contract
• Now suppose Paula contracts to pay Arthur for each duck he
sells (a hire contract).
– If she pays him $12 per duck, Arthur just breaks even on
each sale because m = 12.
– Even if he agrees to this contract, he requires supervision
because he gets no marginal profit from selling one more
duck.
• Paula must offer Arthur more than m per duck for him to have
incentive to sell as many as he can.
– Such a contract is not incentive compatible.
– Joint profit maximization requires MR = MC, and Paula’s
offer >m means she directs Arthur to sell fewer ducks than
is optimal.
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19.2 Full Information: Revenue-Sharing
Contract
• Now suppose Paula and Arthur use a contingent
contract to share the revenue.
– Arthur receives ¾ R; Paula receives ¼ R.
• Under this revenue-sharing contract, Arthur’s MR curve is
below MR in a different type of contract.
– For example, selling 12 ducks no longer brings in $12 in
additional revenue; 12 ducks brings in ¾ $12 = $9 in MR.
• Thus, joint profit is not maximized when the agent
maximizes his own profit in this type of contract.
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19.2 Full Information: Revenue Sharing
• Agent chooses a to
maximize ¾ revenue
less entire cost.
• Agent chooses
inefficient effort.
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19.2 Full Information: Profit-Sharing
Contract
• Now suppose Paula and Arthur use a contingent
contract to share the profit.
– Arthur receives one-third of the joint profit.
• Under this profit-sharing contract, Arthur only earns onethird of the profit, but also only bears one-third of the MC.
• Joint profit is maximized when the agent maximizes his
own profit; profit-sharing is efficient.
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19.2 Full Information: Profit Sharing
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19.2 Asymmetric Information
• Now assume that the principal, Paula, has less information than
the agent, Arthur.
– She can’t observe the number of ducks he sells or the
revenue.
• What occurs under the four different contract types?
– Fixed-fee contract yields joint-profit-maximizing quantity.
– Hire contract results in less-than-optimal quantity if Arthur
is honest and greater-than-optimal quantity if he is not.
– Revenue-sharing contract is still inefficient.
– Profit-sharing contract is efficient if he reports revenue
and cost to Paula honestly.
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19.2 Production Efficiency
Summary (1 of 2)
• With asymmetric information, only a fixed-fee contract is efficient and
has no moral hazard problem.
Fixed-fee rental contract
Contract
Full Information
Production Efficiency
Asymmetric Information
Production Efficiency
Asymmetric Information
Moral Hazard Problem
Yes
Yes
No
Full Information
Production Efficiency
Asymmetric Information
Production Efficiency
Asymmetric Information
Moral Hazard Problem
Pay equals marginal cost
Noa
Nob
Yes
Pay is greater than
marginal cost
Noc
No
Yes
Rent (to principal)
Hire contract, per unit pay
Contract
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19.2 Production Efficiency
Summary (2 of 2)
Contingent contract
Contract
Full Information
Production Efficiency
Asymmetric Information
Production Efficiency
Asymmetric Information
Moral Hazard Problem
Share revenue
No
Nob
Yes
Share profit
Yes
Nob
Yes
aThe
agent may not participate and has no incentive to sell the optimal number of carvings. Efficiency
can be achieved only if the principal supervises.
bUnless
cThe
the agent steals all the revenue (or profit) from an extra sale, inefficiency results.
agent sells too many or the principal directs the agent to sell too few carvings.
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19.3 Trade-Off Between Efficiency in
Production and in Risk Bearing (1 of 2)
• Usually, a contract does not achieve efficiency in production and
in risk bearing.
– There exist trade-offs between these two objectives.
• Example: Contracting with a lawyer
– Pam is the principal who has been injured in a traffic accident.
– Alfredo is the agent and is her lawyer.
– Pam faces uncertainty due to risk and asymmetric information.
– Trial outcome depends on Alfredo’s hours of effort, a, and
attitudes of the jury (state of nature, θ).
– Pam never learns θ, so if she loses the case, she doesn’t
know if it was because Alfredo didn’t work hard enough.
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19.3 Trade-Off Between Efficiency in
Production and in Risk Bearing (2 of 2)
• The choice of various possible contracts between Pam and
Alfredo affects whether they achieve efficiency in production
or in risk bearing.
Type of Contract
Fixed Fee
to Lawyer
Lawyer’s payoff
Client’s payoff
Production
efficiency?
(a, )  F
No*
Who bears risk?
Client
F
Fixed Payment Lawyer Paid
to Client
by the Hour
(a, )  F
F
Yes
Lawyer
wa
(a, )  wa
No*
Client
Contingent
Contract
(a, )
(1   )(a, )
No*
Shared
*Production efficiency is possible if the client can monitor and enforce optimal effort by the lawyer.
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19.3 Choosing the Best Contract
• The best contract between Pam and Alfredo depends on,
among other factors:
– Attitudes toward risk
– The degree of risk
– The difficulty of monitoring
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19.4 Monitoring to Reduce Moral
Hazard (1 of 5)
• When a firm can’t use piece rates or rewards, they usually
pay fixed-fee salaries or hourly wages.
– These methods may encourage shirking and/or
inflating work hours.
– Firm can reduce shirking through increased monitoring.
• Monitoring eliminates the asymmetric information problem
because both the employer and the employee know how
hard the employee works.
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19.4 Monitoring to Reduce Moral
Hazard (2 of 5)
• Types of monitoring:
– Requiring punching a time clock
– Installing surveillance cameras
– Installing assembly lines (sets work pace)
– Recording employees’ voicemail, email, phone calls
– Reviewing employees’ computer files
• Monitoring is most common in the financial sector, in which
81% of firms use the above techniques.
• Monitoring may lower morale and, in turn, productivity.
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19.4 Monitoring to Reduce Moral
Hazard (3 of 5)
• A direct approach to ensuring good behavior by agents is
to require they deposit funds guaranteeing good behavior.
– A performance bond is an amount of money that will
be given to the principal if the agent doesn’t complete
assigned duties or achieve specific goals.
• Suppose worker’s value on gain from shirking is $G and
the worker must post a bond of $B, which is forfeited if he
is caught shirking.
– If θ is the probability of being caught shirking, a riskneutral worker won’t shirk if G ≤ θB (gain ≤ expected
penalty).
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19.4 Monitoring to Reduce Moral
Hazard (4 of 5)
• The minimum bond that discourages shirking is
G
B

– Bond must be larger the higher the value the employee
places on shirking and the lower the probability of being
caught.
• Employers like bonds because it reduces monitoring
necessary to discourage moral hazards.
– More commonly used to deter theft than shirking.
– Workers may not have enough money to post a bond.
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19.4 Monitoring to Reduce Moral
Hazard (5 of 5)
• Firms discourage shirking by raising an employee’s cost of
losing a job.
• An alternative is for the firm to pay an unusually high
wage, called an efficiency wage.
– If the going wage is w , an efficiency wage is w  w ,
• The extra earnings, w  w , serves the same function as
the bond, B, in discouraging bad employee behavior.
w w 
G

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19.5 Contract Choice (1 of 2)
• A firm may choose to concentrate on hiring industrious
workers rather than on stopping lazy workers from
shirking.
– Such a firm seeks to avoid moral hazard problems by
preventing adverse selection.
• Firms may be able to determine which prospective workers
will work hard by giving them a contract choice.
– Those who select contingent contracts, in which pay
depends on how hard they work, signal they are hard
workers.
– Those who choose fixed-fee contracts signal they are
lazy workers.
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19.5 Contract Choice (2 of 2)
• Workers sort themselves when the firm offers two different
contracts
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19.6 Checks on Principals (1 of 3)
• Because employers (principals) often pay employees
(agents) after work is completed, employers have many
opportunities to exploit workers.
• Source of employer’s opportunistic behavior: asymmetric
information.
• Solutions:
– Firms provide workers with information about company
profits
– Firms may rely on a good reputation.
– Use less efficient contracts, such as ones that base
employee payments on easily observed revenues rather
than less reliable profit reports.
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19.6 Checks on Principals (2 of 3)
• During recessions, why are layoffs more common than
wage reductions?
• Workers cannot observe actual profits of their employers.
• For wage cuts, firms have incentive to claim conditions are
bad, even when they are good.
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19.6 Checks on Principals (3 of 3)
• But with layoffs, firms have the incentive to honestly report
conditions to workers.
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Challenge Solution
• Question
– Does evaluating a manger’s performance over a longer period using
delayed compensation or clawback provisions lead to better management?
• Concerns
– In a multiyear problem in which manager shares profits but not losses
– Managers may increase this year’s profit in a way that lowers profits in
future years
– Manager receives bonus for this year’s profit, but is not penalized for
losses in future years
– Manager engages in reckless behavior that increases this year’s profit but
bankrupts the firm next year
• Solution
– Pay bonuses based on multi-year performance
– Manager takes into account effect of current actions on future profits
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