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.

Maximising Joint Profit and a Fixed Fee Contract (a) Agent ’ s Problem 24 Maximising Joint Profit and a Fixed Fee Contract Agent’s marginal revenue, $ per carving e 12 MC Demand MR 12 24 a , Duck carvings per day (b) Profits E 72 Agent’s profit, $ π , Joint profit Principal owns a shop by a pond Begin by assuming that the agent is the firm find that joint profit maximised where MC =MR, an output of 12. Fixed fee merely reduces profits at all outputs and doesn’t affect MR. Joint profit still maximised. E * π – 48, 24 Agent ’ s profit 12 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: Contract is not incentive compatible

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

Profit Sharing 72 π , Joint profit 1 – π , Agent ’ s profit 3 24 12 24 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. This is not so much about a trade off more about the difficulty of achieving both. Lawyer is likely to handle many such cases and is therefore likely to be close to risk neutrality. The agent only has one and so is risk averse. The situation is reversed if the lawyer is a small firm and the client is an insurance company.

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