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Contracts and Moral Hazards Perloff Chapter 20. Principal Agent Problem Contract with an individual whos actions are not observed. Individual may not.

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Presentation on theme: "Contracts and Moral Hazards Perloff Chapter 20. Principal Agent Problem Contract with an individual whos actions are not observed. Individual may not."— Presentation transcript:

1 Contracts and Moral Hazards Perloff Chapter 20

2 Principal Agent Problem Contract with an individual whos 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 agents 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 Maximising Joint Profit and a Fixed Fee Contract 12 24 72 24 0 1224 01224 MC MR e a, Duck carvings per day Demand π, Joint profit a, Duck carvings per day (a) Agents Problem (b) Profits π – 48, Agents profit E * E Agents marginal revenue, $ per carving Agents profit, $

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 Revenue sharing Contingent contract (dependent on revenue) Agent gets ¾ of the revenue. Not Incentive compatible 12 18 24 64 72 24 8 0 1224 01281624 MC MR ee* a, Duck carvings per day π, Joint profit Agents profit a, Duck carvings per day (a) Agents Problem (b) Profits MR * = 3 – 4 R – 12a, 3 – 4 E * E Agents marginal revenue, $ per carving Agents profit, $

8 Profit Sharing 72 24 01224 π, Joint profit a, Duck carvings per day π, Agents profit 1 – 3 Agents profit, $

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


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