Microeconomics

Eighth Edition

Chapter 20
Moral Hazards
and Contracts

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The Principal-Agent Problem (1 of 2)
• The principal, Paul, owns many ice cream parlors
across North America.
• Paul contracts with Amy, the agent, to manage his
Miami shop. Her duties include supervising workers,
purchasing supplies, and performing other necessary
actions.

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The Principal-Agent Problem (2 of 2)
• The shop’s daily earnings depend on the local
demand conditions and on how hard Amy works.
Demand for ice cream varies with the weather, and is
high half the time, and low otherwise.

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Efficiency
• Efficient contract - an agreement in which neither
party can be made better off without harming the other
party.
• Efficiency in production - situation in which the
principal’s and agent’s combined value (profits,
payoffs), π, is maximized.
• Efficiency in risk bearing - a situation in which risk
sharing is optimal in that the person who least minds
facing risk—the risk-neutral or less risk-averse person
— bears more of the risk.

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Symmetric Information (1 of 2)
• Moral hazard is not a problem if Paul lives in Miami
and can directly supervise Amy.
• They could agree to a contract that specifies Amy
receives 200 per day if she works extra hard, but
loses her job if she doesn’t.

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Ice Cream Shop Outcomes (1 of 3)
Table 20.1 Ice Cream Shop Outcomes
Expected Expected Expected
Payoffs of Payoffs of Payoffs of Amy’s Efficiency of Efficiency of
Contract Paul Amya Paul + Amy Variance Risk Bearingb Joint Payoffc
Symmetric
Information
Perfect 200 160 360 0 Yes Yes
monitoring
Asymmetric
Information

a
If Amy puts in extra work, her payoff is her earnings minus 40, which is the value she
places on having to work harder.
b
Because Amy is risk averse and Paul is risk neutral, risk bearing is efficient only if Paul
bears all the risk, so that Amy’s variance is zero.
c
Production is efficient if Amy puts in extra work, so that the shop’s expected payoff is 400
rather than 200.
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Ice Cream Shop Outcomes (2 of 3)
[Table 20.1 Continued]
Expected Expected Expected
Payoffs of Payoffs of Payoffs of Amy’s Efficiency of Efficiency of
Contract Paul Amya Paul + Amy Variance Risk Bearingb Joint Payoffc
Fixed wage of 100 100 200 0 Yes No
100
Licensing fee 200 160 360 10,000 No Yes
of 200
State- 200 160 360 0 Yes Yes
contingent fee
of 100 or 300

a
If Amy puts in extra work, her payoff is her earnings minus 40, which is the value she
places on having to work harder.
b
Because Amy is risk averse and Paul is risk neutral, risk bearing is efficient only if Paul
bears all the risk, so that Amy’s variance is zero.
c
Production is efficient if Amy puts in extra work, so that the shop’s expected payoff is 400
rather than 200.
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Ice Cream Shop Outcomes (3 of 3)
[Table 20.1 Continued]
Expected Expected Expected
Payoffs Payoffs of Payoffs of Paul Amy’s Efficiency of Efficiency of
Contract of Paul Amya + Amy Variance Risk Bearingb Joint Payoffc
50% profit share 200 160 360 2,500 No Yes

Wage and bonus of 200; 200 160 360 10,000 Yes Yes
Amy is risk neutral
Wage and bonus of 200; 100 100 200 0 Yes No
Amy is very risk averse

a
If Amy puts in extra work, her payoff is her earnings minus 40, which is the value she
places on having to work harder.
b
Because Amy is risk averse and Paul is risk neutral, risk bearing is efficient only if Paul
bears all the risk, so that Amy’s variance is zero.
c
Production is efficient if Amy puts in extra work, so that the shop’s expected payoff is 400
rather than 200.
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Asymmetric Information
• Fixed-fee contract - one party pays the other a
constant payment or fee.
• Because Amy receives the same amount no matter
how hard she works, Amy chooses not to work hard,
which is a moral hazard problem.
• Paul bears all the risk, so risk bearing is again
efficient. However, the expected combined earnings
are less than in the previous example with symmetric
information.

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Fixed-Fee Contracts
• Amy could pay Paul a fixed amount so that she
receives the residual profit.
• Amy is, in effect, paying a license fee to operate
Paul’s ice cream shop.
• With such a contract, Paul bears no risk as he
receives a fixed fee, while Amy bears all the risk.
• This contract maximizes combined expected earnings,
it does not provide for efficient risk bearing.

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State-Contingent Contracts
• State-contingent contracts - one party’s payoff is
contingent on only the state of nature.
• Suppose Amy pays Paul a license fee of 100 if
demand is low and a license fee of 300 if demand is
high and keeps any additional earnings.
• This state-contingent contract is fully efficient even if
Paul cannot monitor Amy’s effort.

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Profit-Sharing Contracts
• Profit-Sharing Contracts - in which the payoff to
each party is a fraction of the observable total profit.
• Profit sharing may reduce or eliminate the moral
hazard problem, especially if the agent’s share of the
profit is large, but may not do so if the agent’s share is
small.

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Bonuses and Options
• Bonus - an extra payment if a performance target is
hit.
• Option - gives the holder the right to buy up to a
certain number of shares of the company at a given
price (the exercise price) during a specified time
interval.

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Piece Rates
• Piece-rate contract - in which the agent receives a
payment for each unit of output the agent produces.
• Owners often use piece rates if they can observe
output but not labor.

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Commissions
• When at least one party cannot observe total profit,
but both can observe revenue, they use a revenue-
sharing contract: the agent receives a share of the
revenue. For people who work in sales, such
payments are called commissions.

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Choosing the Best Contract
• Which contract is best for a principal and an agent
depends on their attitudes toward risk, the degree of
risk, the difficulty in monitoring, and other factors.
• Contingent fee - a payment to a lawyer that is a
share of the award in a court case (usually after legal
expenses are deducted) if the client wins and nothing
if the client loses.

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Monitoring to Reduce Moral Hazard
• Monitoring eliminates the asymmetric information
problem:
‒ Both the employee and the employer know how hard
the employee works.
• Shirking - a moral hazard in which agents do not
provide all the services they are paid to provide.

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Bonding
• Performance bond - an amount of money that will be
given to the principal if the agent fails to complete
certain duties or achieve certain goals.

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Bonding to Prevent Shirking (1 of 3)
• Suppose that the value that a worker puts on the gain
from taking it easy on the job is G dollars.
• If a worker’s only potential punishment for shirking is
dismissal if caught, some workers will shirk.

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Bonding to Prevent Shirking (2 of 3)
• Suppose that the worker must post a bond of B dollars
that the worker forfeits if caught not working.
• Given the firm’s level of monitoring, the probability that
a worker is caught is θ.
• Thus, a worker who shirks expects to lose θB.

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Bonding to Prevent Shirking (3 of 3)
• A risk neutral worker chooses not to shirk if the certain
gain from shirking, G, is less than or equal to the
expected penalty, θB, from forfeiting the bond if
caught: G ≤ θB.
• The minimum bond that discourages shirking is

G
B


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Trade-Off Between Bonds and
Monitoring
• The larger the bond, the less monitoring is necessary
to prevent shirking.
• Suppose that a worker places a value of G = $1,000 a
year on shirking. A bond that is large enough to
discourage shirking is
– $1,000 if the probability of being caught is 100%,
– $2,000 at 50%,
– $5,000 at 20%,
– $10,000 at 10%, and
– $20,000 if the probability of being caught is only 5%.

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Solved Problem 20.5
• Workers post bonds of B that are forfeited if they are
caught stealing (but no other punishment is
imposed). Each extra unit of monitoring, M, raises
the probability that a firm catches a worker who
steals, θ, by 5%. A unit of M costs $10. A worker can
steal a piece of equipment and resell it for its full
value of G dollars. What is the optimal M that the firm
uses if it believes that workers are risk neutral? In
particular, if B = $5,000 and G = $500, what is the
optimal M?

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Solved Problem 20.5: Answer
1. Determine how many units of monitoring are
necessary to deter stealing.
2. Determine whether monitoring is cost effective.
3. Solve for the optimal monitoring in the special case.

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Problems with Bonding
• To capture a bond, an unscrupulous employer might
falsely accuse an employee of stealing.
• Workers may not have enough wealth to post them.

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Deferred Payments
• A firm may offer its workers one of two wage payment
schemes.
– The firm pays w per year for each year that the
worker is employed by the firm.
– The starting wage is less than w but rises over the
years to a wage that exceeds w.

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Efficiency Wages
• Efficiency wage - an unusually high wage that a firm
pays workers as an incentive to avoid shirking.
• Suppose that a firm pays each worker an efficiency
wage w, which is more than the going wage w that an
employee would earn elsewhere after being fired for
shirking.

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How Efficiency Wages Act like
Bonds (1 of 2)
• A shirking worker expects to lose
θ(w − w),
– where θ is the probability that a shirking worker is
caught and fired.
• A risk-neutral worker does not shirk if the expected
loss from being fired is greater than or equal to the
gain from shirking:
θ(w − w) ≥ G.

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How Efficiency Wages Act like
Bonds (2 of 2)
• The smallest amount by which w can exceed w and
prevent shirking is determined:
G
w w 


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Contract Choice (1 of 2)
• Often a principal gives an agent a choice of contract.
• By observing the agent’s choice, the principal obtains
enough information to prevent agent opportunism.

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Contract Choice (2 of 2)
• The firm seeks to avoid moral hazard problems by
preventing adverse selection,
– whereby lazy employees falsely assert that they are
hardworking.
 Signal
 Screen out

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