Contracts and Moral Hazards

1. Contracts and Moral Hazards Perloff Chapter 20

2. 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

3. 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.

4. 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.

5. (a) Agent ’ s Problem 24 Maximising Joint Profit and a Fixed Fee Contract Agent’s marginal revenue,$ per carving e 12 MC Demand MR 0 12 24 a , Duck carvings per day (b) Profits E 72 π , Joint profit Agent’s profit, $ * E π – 48, 24 Agent ’ s profit 0 12 24 a , Duck carvings per day

6. 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: • Contract is not incentive compatible

7. Contingent contract (dependent on revenue) Agent gets ¾ of the revenue. Not Incentive compatible (a) Agent ’ s Problem 24 Revenue sharing 18 Agent’s marginal revenue,$ per carving e * e 12 MC MR 3 * = – MR MR 4 0 8 12 24 a , Duck carvings per day (b) Profits E 72 64 π , Joint profit Agent’s profit, $ * E 3 24 – R – 12 a , 4 Agent ’ s profit 0 8 12 16 24 a , Duck carvings per day

8. Profit Sharing 72 π , Joint profit Agent’s profit, $ 1 – π , Agent ’ s profit 3 24 0 12 24 a , Duck carvings per day

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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

18. Example of contract choice