A free-rider problem with a free-riding principal

In a moral hazard problem caused purely by joint production and not by uncertainty, we examine the problem faced by a principal who actively participates in production along with a group of agents. We show that, when designing the optimal output sharing rule, the principal need not look for anything more complicated than the frequently observed simple linear or piecewise linear rules. We also confirm the presence of a friction between the principal’s residual claimant role and her incentive to free-ride in the production process that prohibits her from completely mitigating the moral hazard problem. This paper is from the first chapter of my Ph.D. dissertation at The University of British Columbia, Canada, 1993. I would like to thank my thesis supervisor John Weymark for his many helpful comments and suggestions. I have also benefitted from the comments of Charles Blackorby, David Donaldson, Mukesh Eswaran, Kenneth Hendricks, Ashok Kotwal and Guofu Tan. An anonymous referee and an associate editor provided helpful suggestion. I am also grateful for the hospitality of the Indian Statistical Institute, Delhi Centre, and the Centre for Development Economics, Delhi School of Economics, where parts of the paper were revised while I was a visitor. I am solely responsible for any remaining errors and omissions.