Moral Hazard: The Trade-Off Between Limited Liability Rent Extraction and Efficiency

Let us consider a risk-neutral agent. As we have already seen, (4.3) and (4.4) now take the following forms: and Let us also assume that the agent’s transfer must always be greater than some exogenous level −l, with l ≥ 0. The framework is quite similar to that of section 3.5, and we refer

Moral Hazard: The Trade-Off Between Insurance and Efficiency

Let us now turn to the second source of inefficiency in a moral hazard context— the agent’s risk aversion. When the agent is risk-averse, the principal’s program is written as: It is not obvious that (P) is a concave program for which the first-order Kuhn and Tucker conditions are necessary and sufficient. The reason for

Moral Hazard: More than Two Levels of Performance

We now extend our previous 2 × 2 model to allow for more than two levels of performance.8 We consider a production process where n possible outcomes can be realized. Those performances can be ordered so that q1 < q2 < ··· < qi < ··· < qn. We denote the principal’s return in each

Moral Hazard: Informative Signals to Improve Contracting

As in the case of adverse selection analyzed in section 2.14, various verifiable signals can be used by the principal to improve the provision of incentives to the agent in a moral hazard framework. These pieces of information can be gathered by different kinds of information systems that are internal to the organization in

Moral Hazard: Moral Hazard and the Theory of the Firm

The trade-off between risk and incentives provides one possible explanation of the wage compensations used in firms. The widespread use of stock options for CEOs can be seen as a result of the desire of the firm’s owners to let these agents bear more risk so that they are better incentivized. Similarly, the use

Moral Hazard: Contract Theory at Work

This section elaborates on the moral hazard paradigm discussed so far in a number of settings that have been discussed extensively in the contracting literature. 1. Efficiency Wage  Let us consider a risk-neutral agent working for a firm, the principal. By exerting effort e in f0h 1i, the firm’s added value is V¯ (resp. V

Moral Hazard: Commitment Under Moral Hazard

The assumption of full commitment to an incentive scheme was already discussed in section 2.12 in the case of adverse selection. This issue is also quite important under moral hazard. For instance, to induce a positive effort level the principal must let the risk-averse agent bear some risk. However, once this effort is sunk,

Incentive and Participation Constraints with Moral Hazard

In chapter 4, we stressed the various conflicts that may appear in a moral hazard environment. The analysis of these conflicts, under both limited liability and risk aversion, was made easy because of our focus on a simple 2 × 2 environment with a binary effort and two levels of performance. The simple interaction

Moral Hazard: More than Two Levels of Effort

1. A Discrete Model  Let us extend the model of chapter 4 by allowing more than two levels of effort. Consider the more general case, with n levels of production q1 < q2 < ··· < qn and K levels of effort with 0 = e0 < e1 < ··· < ek-1 and the disutilities of effort

Moral Hazard: The Multitask Incentive Problem

It is often the case that the agent does not exert a single-dimensional effort, par- ticularly when he is involved in many related activities associated with the same job. Such examples abound, as we will see in section 5.2.5 below. When the agent simultaneously performs several tasks for the principal, new issues arise: How

Moral Hazard: Nonseparability of the Utility Function

The separability in transfer and effort of the agent’s utility function simplifies the principal-agent theory with moral hazard by ensuring that the agent’s participation constraint is binding. However, it neglects one significant incentive effect, namely that one way to provide incentives is to make the agents richer by decreasing their marginal disutility of effort.

Moral Hazard: Redistribution and Moral Hazard

In chapter 3, we have already seen how the conflict between incentive compat- ibility and budget balance leads to the under-provision of output in an adverse selection model. The same qualitative result still holds in a moral hazard environ- ment. Expected volume of trade may be reduced by moral hazard. To illustrate this point,

Nonverifiability in agency theory

When two parties engage in a relationship, it is often the case that they are uncer- tain about the value of some parameter that will affect their future gains from trade. This uncertainty is represented by assuming that the parameter can take several values, each value corresponding to different states of nature whose prob-

Nonverifiability: No Contract at Date 0 and Ex Post Bargaining

With the same model as in chapter 2, we now assume that the parameter θ is unknown at the contracting date (date t = 0) but becomes common knowledge between the two parties, the principal and the agent, later on (at date t = 1). First we examine the case where no initial contract

Nonverifiability: Incentive Compatible Contract

Instead of waiting for the realization of the state of nature, the principal can offer to the agent, at the ex ante stage (date t = 0), a contract that ensures ex post efficiency under some rather weak conditions, as we see in the following. This contract can only be written in terms of

Nonverifiability: Nash Implementation

In section 6.2, we have just seen how the principal and the agent can achieve ex post efficiency through an ex ante contract when they are both risk neutral. This contract uses only the agent’s message but fails to achieve efficiency when the agent is risk-averse or when nonresponsiveness occurs. We now propose a

Nonverifiability: Subgame-Perfect Implementation

From proposition 6.4, a necessary condition for unique Nash implementation is that an allocation rule a(·) be monotonic. Any allocation rule that fails to be monotonic will also fail to guarantee unique Nash implementation. Then, one may wonder if refinements of the Nash equilibrium concept can still be used to ensure unique implementation. The

Nonverifiability: Risk Aversion

The previous sections have discussed how various sorts of mechanisms may help to implement the first-best allocation rule when both the principal and the agent are risk neutral. The objective of this section is to discuss the potential of those mechanisms when either the principal or the agent is risk averse. 1. Risk-Averse Agent 

Mixed Models of agency theory

The pure models of chapter 2 for adverse selection, chapter 4 for moral hazard and chapter 6 for nonverifiability were highly stylized contracting settings. Each of those models aimed at capturing a single dimension of the incentive problems that may be faced by a principal at the time of designing the contract for his

Mixed Models: Adverse Selection Followed by Moral Hazard

In the standard moral hazard framework of chapter 4, it was first assumed that the agent had no private information of his own. In insurance markets, insurees often have some prior information about how risky they are before exerting any effort to prevent this risk. Similarly, in credit markets, a borrower may know the