On the Performance of Linear Contracts

We examine the ability of linear contracts to replicate the performance of optimal unrestricted contracts in the canonical moral hazard setting with a wealth constrained, risk averse agent. We find that in a broad class of environments, the principal can always secure with a linear contract at least 95% of the profit that she secures with an optimal unrestricted contract, provided the productivity of the agent's effort is not too meager.     

Optimal financial contracts with hidden effort,unobservable profits and endogenous costs of effort

This paper studies financial contracting in a two-period financing model with double moral hazard, as entrepreneurial effort choices and profits are unobservable and non-verifiable. The optimal financial contract must induce both the high effort level and truthful revelation of profits. The paper further analyses the structure of the optimal contract where the entrepreneur's payoff takes a general functional form that allows for endogenously determined costs of effort. The entrepreneur's performance is influenced by not only extrinsic work motivation factors but also intrinsic factors so that the degree of control imposed by the investor, in the form of end-of-period transfers, affects the entrepreneur's costs of effort. The finding shows that under well-defined conditions, the optimal contract that solves a model with non-verifiable profits also elicits effort, and generally resembles a simple debt contract. The structure of the optimal contract is robust in the general case where the entrepreneur's payoff function is non-linear in transfers.     

Team Incentives and Reference‐Dependent Preferences

We investigate a multi‐agent moral‐hazard model where agents have expectation‐based reference‐dependent preferences à la K?szegi and Rabin (2006, 2007). We show that even when each agent's probability of success in a project is independent, a principal may employ team incentives. Because the agents are loss averse, they have first‐order risk aversion to wage uncertainty. This causes the agents to work harder when their own failure is stochastically compensated through other agents' performance. In the optimal contract, agents with high performance are always rewarded, whereas agents with low performance are rewarded if and only if other agents' performance is high.     

Information Acquisition and the Equilibrium Incentive Problem

I study the optimal incentive provision in a principal–agent relationship with costly information acquisition by the agent. I emphasize that adverse selection or moral hazard is the principal's endogenous choice by inducing or deterring information acquisition. The principal designs the contract not only to address an existing incentive problem but also to implement its presence. Implementation of adverse selection relies on a steeper information rent to the agent than the standard menu, such that the agent is motivated to distinguish the efficient state of nature from the inefficient. Moral hazard is implemented by replacing the benchmark debt contract with a debt‐with‐equity‐share contract, such that the agent does not attempt to acquire information to either avoid debt or to extract rent.     

Dynamic incentive contracts with termination threats

We consider a dynamic moral hazard model where the principal offers a series of short-run contracts. We study the optimal mix of two alternative instruments for incentive provision: a performance based wage (a “carrot”) and a termination threat (a “stick”). At any given point in time, these instruments are substitutes in the provision of incentives. We are particularly interested in the dynamic interaction of these two instruments. Both carrot and stick are used more intensively as the agent approaches the end of his finite life. The sharing of the surplus of the relationship plays a key role: a termination threat is included in the optimal contract if and only if the agent’s expected future gain from the relationship is sufficiently high, compared to the principal’s expected future gain. Also, a termination threat is more likely to be optimal if output depends more on “luck” than on effort, if the discount factor is high, or if the agent’s productivity is low. The model, provided that the optimal contract includes a termination threat, essentially provides an alternative explanation for upward-sloping wage profiles even in the absence of full-commitment.     

Securitization and optimal retention under moral hazard

Securitization improves liquidity in capital markets by allowing originators to remove issued loans from its balance sheet and use the proceeds for other purposes. Securitization is often suspected of being one of the main reasons for the recent financial crisis. One concern is that securitization leads to moral hazard in lender screening and monitoring. By selling loans to investors and removing them from their books, banks have a lesser incentive to carefully evaluate and monitor borrowers’ credit quality to ensure that they can repay their loans. One problem in the literature is that the analysis of securitization is very general and suffers from a lack of specific security design analysis under asymmetric information. We address the moral hazard problem using a principal–agent model where the investor is the principal and the lender is the agent. We show that the optimal contract must contain a retention clause in the presence of moral hazard. The optimal retention is affected by tranching and credit enhancement.     

Motivate and select: Relational contracts with persistent types

We develop a model of relational contracts with moral hazard and asymmetric persistent information about an employee's type. We find that the form of the optimal contract depends on the job characteristics and the distribution of employees' talent. Bonus contracts are more likely to be adopted in complex jobs and when high talent is not too common or too rare. Firms with “normal” jobs are more likely to adopt termination contracts. In labor market equilibrium, different contracts may be adopted by ex ante identical firms. Hence, we offer an explanation for the coexistence of different employment systems within the same industry.     

Peer Evaluation: Incentives and Coworker Relations

In many workplaces, coworkers have the best information about each other's efforts. This paper studies a principal who only observes the joint output by two limitedly liable agents, while agents receive signals about each other's effort levels. The principal attempts to exploit this information through peer evaluation; agents are asked to report their signal and may receive a bonus for being evaluated positively. Lying aversion ascertains that truthful evaluation is possible, while interpersonal relations between colleagues give an incentive to misreport. This paper shows that peer evaluation gives an incentive for effort, even when the evaluations are not truthful. The peer evaluation bonus is constrained by more intensive coworker relations. Still, the optimal contract always includes a peer evaluation bonus, sometimes complemented with a team bonus. Coworker relations have nonmonotonic effects on profits in the optimal contract.     

Targets and Resources: A Screening Perspective

To secure funding for a project, an agent (informed about the project's type) announces a target output. The principal provides more generous resources for high targets but makes compensation tied to performance relative to the projection. The incentive mechanism is geared towards screening project/agent types for resource disbursement at the ex‐ante stage and motivating appropriate efforts at the interim stage. These dual objectives are embedded in an optimal share contract solution: a pair of startup funds and output share between the principal and agent. The target mechanism's performance is then assessed with respect to implementation of the optimal share contract solution. The focus is on linear contracts for their applicability and practical relevance. Copyright © 2016 John Wiley & Sons, Ltd.     

Optimal deterministic contracting mechanisms for principal-agent problems with moral hazard and adverse selection

For the principal-agent problem with moral hazard and adverse selection we establish that within the collection of all measurable, deterministic contracting mechanisms satisfying the individual rationality and incentive compatibility constraints there exists one that is optimal for a risk averse principal contracting with a risk averse agent. In addition to demonstrating existence, one of the main contributions of the paper is to show that, in general, centralized contracting implemented via a contracting mechanism is equivalent to delegated contracting implemented via a contract menu. Thus, contracting can always be delegated to the agent without gain or loss to the principal. Based on this result, the existence of an optimal contracting mechanism for the principal-agent problem is established by showing that there exists an optimal contract menu for the equivalent delegated contracting problem. Received: 7 October 1994 / Accepted: 14 January 1997     

Locally robust contracts for moral hazard

We consider a moral hazard problem in which the principal has a slight uncertainty about how the agent’s actions translate into output. An incentive contract can be made robust against an $ϵ$ amount of uncertainty, at the cost of a loss to the principal on the order of $\sqrt{ϵ}$, by refunding a small fraction of profit to the agent. We show that as $ϵ$ goes to zero, this construction is essentially optimal, in the sense of minimizing the worst-case loss, among all modifications to the contract that do not depend on the details of the environment.     

On the generalized principal-agent problem: Decomposition and existence results

This paper addresses the class of generalized agency problems: situations in which adverse selection and moral hazard are jointly present. We present a decomposition of the principal's optimization problem under the first-order approach that sheds light on the interactions between the two types of private information, and also significantly improves tractability. We use the decomposition to (1) provide examples of closed form solutions of the optimal contract, and (2) analyze the existence of optimal contracts. We also show that the first-order approach is valid in generalized agency problems if the production technology satisfies the linear distribution function condition (LDFC) in actions and types. For more general production technologies the Mirrlees-Rogerson sufficient conditions need to be extended to include restrictions on the form of the optimal contract. Received: 11 August 1997 / 26 September 1999     

Design of firm‐specific training in an agency relationship: Who should take the initiative?

This paper considers the twofold problem of compensation contracting and the design of a human capital investment scheme. Before contracting, the principal and the agent can engage in a joint stochastic production process of exerting effort to raise the agent's productivity in the firm. The principal can employ synchronous effort exertion, or either actor can assume a leadership role. We determine which organizational design is best for the principal at the endogenously optimal compensation contract, depending on how the efforts interact.     

Stochastic costly state verification and dynamic contracts

I consider a dynamic costly state verification environment in which a risk-averse agent enters into a contract with a risk-neutral principal. The agent has random income which is unknown to the principal but can be verified at a cost. The principal can commit to executing random verifications.I extend the standard recursive methods to study the problem and show that it is optimal to set verification probabilities strictly less than 1. If the agent׳s absolute risk aversion declines sufficiently slowly, the principal will use verification regardless of its cost. If the agent's income is verified then he would get consumption and continuation utility strictly higher than if his income were not verified.     

Delegation of risky activities

This paper studies the delegation contract of a risky activity under the presence of adverse selection and moral hazard. The problem is posed as providing incentives from the principal to the agent to enhance the protective action of the agent through payment schemes. Given non‐bankruptcy of both the principal and the agent, the principal rewards the agent if no accident occurs but penalizes the agent if an accident occurs. Given bankruptcy of either the principal or the agent, regardless of the agent's risk type, the agent is only rewarded with the same amount of remuneration and not penalized if the accident occurs. The social welfare level resulting from contracting processes depends on the asset levels of both parties and the agent's technology to reduce risks of the activity. Copyright © 2005 John Wiley & Sons, Ltd.     

Rater Bias and Incentive Provision

The tendency of supervisors to judge an employee as either good or bad and then to seek out evidence supporting that earlier established opinion is regarded as one of the major problems of performance appraisal. We investigate the implications of this rater bias in a dynamic moral hazard model with a wealth‐constrained agent. Although rater bias weakens the agent's incentives to exert effort in late periods, at the same time it strengthens implicit incentives in early periods. Under the optimal contract, as long as rater bias is not overly strong, its adverse effect on late‐period incentives is fully offset by exploitation of stronger early‐period incentives and thereby leaves the principal's profits unchanged.     

Prevention incentives in long‐term insurance contracts

Long‐term insurance contracts are widespread, particularly in public health and the labor market. Such contracts typically involve monthly or annual premia which are related to the insured's risk profile. A given profile may change, based on observed outcomes which depend on the insured's prevention efforts. The aim of this paper is to analyze the latter relationship. In a two‐period optimal insurance contract in which the insured's risk profile is partly governed by her effort on prevention, we find that both the insured's risk aversion and prudence play a crucial role. If absolute prudence is greater than twice absolute risk aversion, moral hazard justifies setting a higher premium in the first period but also greater premium discrimination in the second period. This result provides insights on the trade‐offs between long‐term insurance and the incentives arising from risk classification, as well as between inter‐ and intragenerational insurance.     

Dynamic competitive retail pricing behavior with uncertainty and learning

When competing retailers lack full information about rivals' decision processes, how will dynamic pricing behavior vary from patterns observed in more traditional static or full-information models? We investigate this question in a dynamic alternating-moves duopoly model. Retailers update (linear) conjectures about rivals' future prices in a Bayesian fashion. We show that as observed and expected prices converge, a pricing equilibrium is always achieved, whether or not the conjectured and actual values of the slope of the rival's best response function are consistent. Assuming specific parameter values, we compare equilibrium prices and associated profits in our Bayesian learning model with those obtained under the assumptions of static Nash behavior, collusive behavior and dynamically optimal behavior with full information. We apply the notions of strategic substitutability and strategic complementarity to the analysis and find that when products are strategic complements, conjectures of higher rival price responsiveness lead to higher steady-state prices and profits. The reverse is true for strategic substitutes. We also find that learning about a rival's behavior proceeds more quickly, the less intensely related in demand are products. We find, in general, that equilibrium pricing patterns and profits can vary considerably from those in full-information environments, but that even with grossly wrong beliefs about rival behavior, competing retailers are still attracted to an equilibrium. The analysis suggests not only the value of investigating lessthan-full information situations but also the potential incremental value of signalling greater or less aggressiveness than truly characterizes one's behavior as a strategic option.     

Optimal Loyalty‐Based Management

We study an agency model in which an entrepreneur selects a manager from a candidate set. The selected manager's effort improves the project's potential environment, and is a hidden action. The realized project environment is the entrepreneur's private information. A manager's utility has two components—(i) loyalty, with which the manager values the organization's profit, and (ii) selfishness, with which the manager values the monetary transfer he receives from the entrepreneur. We find that if the manager's task is easy enough, it is optimal to use a purely loyal manager. Otherwise, it can be optimal to use a manager with mixture of loyalty and selfishness—the manager's mixed motivation alleviates the entrepreneur's misrepresenting incentive, and as a result, the output distortion in the optimal contract can be reduced. In addition, when it is optimal to use a manager with mixed motivations, the entrepreneur selects someone who is more selfish than loyal.     

Group Identity and the Moral Hazard Problem: Experimental Evidence

We experimentally examine how real group identity of parties (a principal and an agent) facing a moral hazard problem may attenuate the problem and thereby implement the efficient outcome. We find that, the frequency of the efficient outcome is significantly higher when both parties share the same identity than when they do not. However, when we induce a substantially weaker form of identity or increase an outside‐option payoff offered to the principal, the frequency of the efficient outcome diminishes considerably, even when the parties’ identities align perfectly. Our results have important implications for the design of nonpecuniary contract enforcement devices.