Moral Hazard: The Basic Trade-Offs

In chapter 2, we stressed that the delegation of tasks creates an information gap between the principal and his agent when the latter learns some piece of informa- tion relevant to determining the efficient volume of trade. Adverse selection is not the only informational problem one can imagine. Agents to whom a task has been delegated by a principal may also choose actions that affect the value of trade or, more generally, the agent’s performance. By the mere fact of delegation, the prin- cipal often loses any ability to control those actions that are no longer observable, either by the principal who offers the contract or by the court of law that enforces it. Those actions cannot be contracted upon because no one can verify their value. In such cases we will say that there is moral hazard.

The leading candidates for such moral hazard actions are effort variables, which positively influence the agent’s level of production but also create a disutility for the agent. For instance, the yield of a field depends on the amount of time that the tenant has spent selecting the best crops, or the quality of their harvesting.

Similarly, the probability that a driver has a car crash depends on how safely he drives, which also affects his demand for insurance. Also, a regulated firm may have to perform a costly and nonobservable investment to reduce its cost of producing a socially valuable good. The agent’s action may be a more complex array of decisions that define the agent’s task or his job attributes. The agent may sometimes choose among various projects to be carried out on behalf of the principal, each project being associated with a particular stream of profit for the principal and a particular nontransferable private benefit that the agent may get if this project is selected. For example, the manager of a large corporation may divert the firm’s resources into perks rather than in hiring new engineers for the firm’s research lab.

It is important to stress that, as with adverse selection, moral hazard would not be an issue if the principal and the agent had the same objective function. Crucial to the agency cost arising under moral hazard is the conflict between the principal and the agent over which action should be carried out. The nonobservability of the agent’s action may then prevent an efficient resolution of this conflict of interest, because no enforceable contract can ever stipulate which action should be taken by the agent.

As in the case of adverse selection, asymmetric information also plays a crucial role in the design of the optimal incentive contract under moral hazard. How- ever, instead of being an exogenous uncertainty for the principal, uncertainty is now endogenous. The probabilities of the different states of nature, and thus the expected volume of trade, now depend explicitly on the agent’s effort. In other words, the realized production level is only a noisy signal of the agent’s action. This uncertainty is key to understanding the contractual problem under moral hazard. If the mapping between effort and performance were completely determin- istic, the principal and the court of law would have no difficulty in inferring the agent’s effort from the observed output. Even if the agent’s effort was not observ- able directly, it could be indirectly contracted upon, since output would itself be observable and verifiable. The nonobservability of the effort would not put any real constraint on the principal’s ability to contract with the agent, and their conflict of interests would be costless to solve.

In a moral hazard context, the random output aggregates the agent’s effort and the realization of pure luck. However, the principal can only design a contract based on the agent’s observable performance. Through this contract the principal wants to induce, at a reasonable cost, a high effort from the agent despite the impossibility of directly conditioning the agent’s reward on his action. In general, the nonobservability of the agent’s effort affects the cost of implementing a given action. To illustrate this point we present a simple 2 × 2 model, where a risk-averse agent can choose a binary effort and the production level can be either high or low. A first step of the analysis in this chapter is to study the properties of incentive schemes that induce a positive and costly effort. Such schemes must thus satisfy an incentive constraint. Also, inducing the agent’s voluntary participation imposes a standard participation constraint. Incentive feasible contracts are those satisfying those two constraints. Among such schemes, the principal prefers the one that implements the positive level of effort at minimal cost. This cost minimization yields the characterization of the second-best cost of implementing this effort. In general, this second-best cost is greater than the first-best cost that would be obtained by assuming that effort is observable. The reason is that the incentive constraint is generally binding for the incentive scheme implementing a positive effort at minimal cost.

Once this first step of the analysis is performed, we can characterize the second- best effort chosen by the principal. This second-best effort trades off the principal’s benefit of inducing a given effort against the second-best cost of implementing this effort, The main lesson of this second step of the analysis is that the second-best effort may differ from the first-best one. An allocative inefficiency emerges as the result of the conflict of interests between the principal and the agent.

Let us now see in more detail the terms of the moral hazard trade-offs. When the agent is risk neutral, the nonobservability of effort has no effect on the effi- ciency of trade. Moral hazard does not create any transaction cost. The principal can achieve the same utility level as if he could directly control the agent’s effort. This first-best outcome is obtained through a contract that is contingent on the level of production. The agent is “incentivized” by being rewarded for good production levels and penalized otherwise. Since the agent is risk neutral, he is ready to accept penalties and rewards as long as the expected payment he receives satisfies his ex ante participation constraint. Transfers can be structured to make the agent’s par- ticipation constraint binding while inducing the desirable effort level. One way of doing so is to make the agent residual claimant for the gains from trade and to grasp all these expected gains by means of an ex ante lump-sum transfer.

If the risk-neutral agent has no wealth and cannot be punished, a new limited liability constraint must be satisfied on top of the usual incentive and participation constraints. In this case there is a conflict between the limited liability and the incentive constraints. Indeed, punishment being now infeasible, the principal is restricted to use only rewards to induce effort. This restriction of the principal’s instruments implies that he must give up some ex ante rent to the agent. This limited liability rent is costly for the principal, who then distorts the second-best effort level below its first-best value to reduce the cost of this rent. As in the case of adverse selection and the interim participation constraints of chapter 2, we have a similar rent extraction-efficiency trade-off leading to a downward distortion in the expected volume of trade.

If the agent is risk averse, a constant wage provides full insurance but induces no effort provision. Inducing effort requires the principal to let the agent bear some risk. To accept such a risky contract, the agent must receive a risk premium. There is now a conflict between the incentive and the participation constraints of the agent. This leads to an insurance-efficiency trade-off. To solve this trade-off the principal must distort the complete information risk-sharing agreement between him and the agent to induce effort provision. As we will see in chapter 5, there is no general lesson on how the second-best and the first-best efforts can be compared in a moral hazard environment. However, in the model presented in this chapter, which involves two levels of effort, one can still easily show that a high effort is less often implemented by the principal than under complete information.

In section 4.1 we present the general moral hazard model highlighting the stochastic nature of the production process in a 2 × 2 (i.e., two-effort/two-outcome) setting. We also describe the set of incentive feasible contracts that induce a high level of effort, and we derive the first-best decision rule as a benchmark. In sec- tion 4.2, we show that moral hazard imposes no real transaction cost on the effi- ciency of contracting when the agent is risk neutral. Section 4.3 focuses on the trade-off between extraction of the limited liability rent and allocative efficiency under risk neutrality. Section 4.4 deals with the trade-off between insurance and efficiency under risk aversion. These latter two sections are the core of the chapter. We then extend the basic framework to provide various comparative statics results on the optimal contract. In section 4.5, we generalize our previous insights to the case of more than two levels of performance. This extension is worth pursuing to analyze the conditions on the information structures that ensure the monotonicity of the agent’s compensation schedule in the observed performance. In section 4.6, we investigate the properties of various information systems from an agency point of view. Here we prove an important property: any signal that informs the principal of the agent’s effort should be included as an argument of his compensation payment. Section 4.7 proposes a brief overview of the insights obtained from the moral hazard paradigm to understand the theory of the firm. Section 4.8 develops a number of bare-bones examples where the moral hazard paradigm has proved to be extremely useful. Finally, section 4.9 briefly discusses the assumption of commitment.

Source: Laffont Jean-Jacques, Martimort David (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.

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