AN INTRODUCTION TO THE ECONOMICS OF INFORMATION INCENTIVES AND CONTRACTS Second Edition Inés Macho Stadler David Pérex-Catil ‘andatedy Rear Wat OXFORDTHE MORAL HAZARD PROBLEM Summary ‘Thischpteranarethe moral hazard model The mode dis thse suations in sich the sents behavior snot erable vain the relation. Therefore, ‘cant nlite ter a contact and testers of yest po posed thesymnetrcinormaton modal arm loner adequate ‘The analysis of he moral haar model has wo simple impos First our a tenon ected heft hat when contact fered, ti ec) ake Int acount he decane (the el) tht he ther pry wl ake fhe ace the ‘atop. Theat that there decison caanetbe contd pis sn inpertant ‘cen las nditalsoffectsthe ype of ontractat wl besigned ad he dec sont willbe taken, Secondly the alisha tha the epimal contacts de- ‘Weshow thatforthe contacto infec th behaviour ofthe accepting pasty hes itmus payhim more when the ress rea good signa (he inform) that his e- “Sronwartherequredone Theincentverof the apen mt be inked aja how in ‘ormativ th renltsthat the dion ken the fot caer) was that wich the Principal wanted. 35‘The Moral Hazard Problem 3.1 Introduction In Chapter2 we studied simplereaionship between two parscpants based ‘on one the principal contacting the other, the agent to exert an elo oF tO take some sort of decision, in exchange fora monetary payment. We analysed ‘he reference station in which both participants have the same information, ‘th respect othe variables nd functions determining the relationship (such 2 the production function, or the distribution of the random variable, and ‘ith eect to identities (both know the tity function af the other) and be haviour the relevant decisions of the artiipantsare observable) However t ‘easy to think of uations in which the information of the parties toa con tracts not symmetric tis ao easy to imagine hat the party who has i= Formatonal advantage wl iy tous it to his benefit Inthe chapter we il concenrateonacetain typeof informational asym ‘metry ving odo with the behaviour ofthe agen ring the lationship. As ‘of now, me hall asume that the ain behaviour it notobsreable bythe Principal onifitisobaervable bythe principal tis notverfibl(foraconrt of low). This asymmetric information problem is known 38 moral heard We shall continue to assume that all ther ingredient of the problem are sy ‘metic information. That ff isnot verifiable means that t cor be in- led in thee of the contract since it were, incase of reach of entra, ‘no court of law could know ifthe contract had ely been breached or ol, ‘et us consider afew examples that describe the ype of situation that we ‘want to analyse In labour contract tiscommon tht the effort (ora part of theeffort) a the workers isnot veriable arable. these cases the contract ‘cannot include clauses ofthe ype if see tat you have exerted aot of effort then your wage wll be greater than if you slack: since tis very dif, ifnot Impose, or the firm to prove that the worker has inded lacked Inthe ‘ame ea thelevel of investment of ems specie project isa very dficlt Variable to quantify and soa government that regulates these fms wll, on ‘many ezaion. not be abet this information when tsabihes the op- mal regulation policy. It i lo ery elt for an insurance company 10 serve ust how carefl a cleat as been in oder o avoid accidents and neither the coverage nor the premium can depend on this information. en though the agents effort isnot veriale and so cannot be wed 3 contacted variable, we ssume that the result of thi effor i veriable at the dof the petiod. Consequently, the result obtained wil be included inthe contact that stpultes the agent's pay of the above examples his means ”‘The Moral Hazard Problem thata worker’ wage will depend on the sales rte production achieved, that ‘heamount the government pay replated fm ould depend on itsalesor ‘split or the terme of an insurance contact may depend on the number ‘ndimportanceof the aceldents tha the cient sues “he ener scheme ofthe game that we wil beanaysngsshown in igure 5:1, Chronological the fit place, the principal decides whit contrat ‘fer the agent Then the agent decides wheter or not to accep the relation ‘hip, aconding tothe terms of the contact established by the principal Finally the contracthas been accepted the agen mus decide the efor evel ‘hat he mos desires, given the contract that he has signed. This i ree dec- sony the agent snc effort is not a contacted variable. Hence, when she de signe the contract that defines the relationship, the principal mast bear ia ‘mind tht, after signing the contract, the agent wl choose the effort eve that {sthebest or him personal tlt. ee a coe oe a ee co vr Feat Inorderownderstand the nature ofthe problem facing the principal co sider what would happen if she proposes the eficient contac (the sation oundin Chapter 2) when the agent’ efor isnot a contracted variable. Con: sider the at of isk-neuta principal anda rl-vese agent Real hain ‘his ae, the symmetric information optimal contac i forthe pincpal 0 completely nau the agent. However, the agent effort is nat observable, fnce he assigned the contract he will exert the effort level that s most beneficial fr hime Since the wage is ndependent ofthe elt the agent ‘na situation in which is wage doesnot depend on his efor, and so he will, ‘ie the lowest possible effort Consequently the principal wll obtain lower ‘expected profit than that corresponding tothe symmetric information ita ston since the agent ote diferent (es than) the ecient lve, ‘With contract based ona fied wage, the agents bhaviou wl always be ‘hesame: he wl choose the smallest posible efor. Te principal willantip ate this reaction, and oi he propoesa contact based on a fied payoff she sllchoowe the wage that eral compensates the agent forthe eflot he we ‘Therefoce the wage willbe wits defined by ‘The Moral Hazard Problem i =e + (0, where e0"s the smallest possible effort! Tnitimpossibeto achieve greater eflort than ender contractsthat com plete insure the agen. However the principal can make the gent interested’ Inthe consequence of hs behaviour, by making his pay-off depend on thee fut obtained. In onder to understand how thi work, consider the follow: ing in site ofthe principal riskaeutalty and the agents rik-sversion,& franchise-type contact issgned under which the ageat buys the production from the principal In his case he principal receives fied payment andthe partcpant who acceptsllthe isk the agent Ovo the agen snow in terested inthe result However given th diferences in the objective anton, hes not interested inthe esti the sare way asthe principal Besides, the Franchise contact wat loa postin the symmetric information cae If thepincpal di not usethis contract Tormat, twas because the agent des not enjoy taking risks and he snot prepared to pay too much oacept thers involved This is why the franchise snot efficient. A fanchse ives the agent ‘nentves although perhaps not the est ones) but ata ver igh cox "ven if fanchse doesnot appear tobe the best solution to ou curent problem it doesmake one ofthe characteristics of moral haard modes cater Evident the ade af between econ, inthe sense ofthe optimal distrib mots and incentives Thistradeofis wats defined bythe optimal con tin this type of situation. Throughout this chapter we wl be ntrested in studying the characteristics ofthis optimal contract. 3.2 The Moral Hazard Problem In onde to study the optimal contact under conditions of asymmetric in formation with respect ofr, we need to formally define the problem. We wills the mode of Chapter 2 bat ways bearing it mind tha since efforts ow nota verifiable arabe the principal canatinclade the efot vei the terms ofthe contact. In oer words the principal an’ propos’ acertain e- Forsbutshe mat make sae that hii prcisl the eve that he agent wants * ecstacy be aia rpc tang ent eine) scat eg er ed Su cu he fan eet oan oy ‘Suthep ar eso m ance eel Wnt ne get pny era See cerning 9‘The Moral Hazard Problem toexert Theda sto slethe game shown in igure 3.1Thenataral solution ‘Snerp subgame perfect equibrium. The inal tage ofthe game —and ths isthe fondamentl pont ofthe moral hazard problemi that in which the ‘gent choose the effort he will zt This choiee ean be writen a cewani| Ercauiwts)-00} on “his condition what we sal ll the incentive resto or the nentve ompatibily constaint This estriton reflects the moral hazard ‘nce the contact hasbeen aceptd and sine effort ino verifiable (tis pot Incladed nthe terms ofthe contrat, the agent wl choose that evel of effort that maximizes his objective faction, Inthe second sage ofthe game, given the effort that he wll exert and the contract terms the agent decides whether or otto acepthe contact thatthe ringpa is proposing Formally, E poruiw(a))-v(oe2w. 0 ‘We shall refer to thi etition asthe participation constant or the individ al atonlty condition, and it was preset in the synmetic information ‘amework Equation (3.2) reflects the fact thatthe agent can aay reject the Contac if what he gets by signing tno at east equal o what he can obain fromthe alternatives inthe market Inthe rst stage ofthe game the principal designs the contract anticipating ‘the agent's behaviour, Formal. the contact thatthe principal proposes the soltion to the allowing problem: Max Ep(e)Boy-wla)) Letts i ey ae Epfouiwiay )-vd2u, oa cea {Epon )-veoh on whee the firs restriction i the participation constraint (3.2) andthe second the incentive compatibility constrain (3.1 ‘When the agent an choose between afinte,but large, numberof fort ev= elsor whe effort i continuo arable thi problem is dificult anase ‘nd posts solution problems. We wil consider thee problems ater on. Fis tre lok a the conclusions we get ina simple framework that easier alge. “The Moral Hazard Problem 33 2. The Agent Chooses between Two Effort Level Many ofthe conclusions of more general models canbe obtained by studying the problem in which the agent can choose between ony two poste efor levels high (H) 2nd low (1). Thiscase xy to analy We shall assume ‘hatte principals isk-neatra This hypothesis simplifies the analysis and, ove all allows uo determine the fle hat the asymmetric information baton the form ofthe optimal contest since under symmetric information the optimal contract isa fixed payment to the agent. Ay deviation from this contractual form is det the existence ofthe moral azar probe. “The oter case hati eany to solve isha in which the agent sk nt However thi situation isnot interesting sine a franchise, that sto the same contact asin symmeticinformation solves the problem Thiscae docs notalow uso se how information inflenesthe optimal contrat, ince the ‘symmetry in thi station inafensine® Consequent we concenrateon 3 relationship involving risk-avers agen. ‘We assume that effort can only take two posible values ¢ ee. The level efrepreent the situation in which the agent works hard, wile exerting «sean that hes being ay or slacking, Natural the dst of effort fresterwhen the agent works hard than for alany agents v(e) > ve). ln the Interest of imply, we order the set of resale X fom worst to est 5, < <_< Let p= pe bethe probability that theres willbe when the agentoffetshigh fort forall ic (1,2...) Inthesame way, we denoteby P= pe) the probability that theres willbe when the agent offers low effort We assume that for al rests these probable are geate than 220 Finale principal prefers high fot alow: One casein which productivity isgreter given igh effort than given low eft is when pst order stocha. ‘aly dominates thas, EatcE nh tral k This inequality represent this fact that bad ests re mote ly when the agent slay than when he works hard Orin other words its ease tat the "esl ester than (foray ken when effort is igh than when ti ow, isobviouly ue that,"The Moral Hazard Problem tis easy to understand tha, the piacpal demands low effort, hen 90 teuemoral hazard problem exits Its enough o pay the agen axed amount, ‘he sme that he would be pad under symmetric information in onde izarantee him his reservation uty evel, and the agen wl choose oo see this mot that given fixed pay-off, the agent wl alway choot he minim effort evel since this wil maximize his uty (minimizes dusty of fort, Therefore, the optimal contact under symmetric information fore, hich was to offer the agent the fixed wage w=! (U+ (€)satistes the Incentive compatibtyonstrunt only ifthe principal indeed demandsthe ef. fortes ot) 2). “The symmetric information contact continues tobe optimal in thi case "The problem becomes interesting i Uh principal demands (which wl beth ese when the good results ate very trative or nother words when is large for large )-As we have pointed out earl, ny fixed payment even that which optinal under synmeti information fre wil only gt the ‘agent to choos In de thatthe agent chooses ewe ned to search fora ‘ntact under which his pay-off depends onthe final esl achieved In this ‘iethe nentve compatiblity constraints writen a follows: Pitaloe(a) )— (092 peut) Hl, which amb writen Eto pel ucts) ) 2 v0 —v(e. 6s) ‘Condition (3.3) has avery intuitive interpretation. The agent wil choose ef fort eel ef the expected tty gain associated wih this efforts preater ‘han the implied increase in cos (sti). In order to calculate the optimal contact under which the agent chooses high effort the principal must sore the following problem ox Sprig 00) xMhie, ns * psy se Eppudwts) )-veen2w 6a) Supninerpiaverne. 09 ‘The Moral Hazard Problem ‘We now search forthe contracts tht ate candidates for the slain wo prob Jem [thats those points that ais che Kaho Tucker conditions of the problem, The Lagrangeanof the system i: Lata d= Spe mts oS paten?-oo- sn[Etoe an ecwe-ven ene DifeeniatetheLagrangean with respetto the wage (x forall “Thefis-order conditions are pits Agi ors) + my which educesto, pt Twa) Al W (06s) )= 0, forall = Byam Ppp forall com G5) Summing equation (33) rom nd bearing mind hat EA pMeE Dg hve a wei Sot, ; Feet 7? a (oe should point out that, in spite ofthe incentive constraint not being concave funtion in wages the solution of the fistorder conditions is ‘maximam)+ Therefore, the Kuhn-Tacker condition with respect t0 the ‘apm Enrta-wete maton trate -Aete-aoen Themcnl det apnyn wth rope mie al smin-n way eta nyt hep a tha ade cnn cet ats Traton 83 ttf pss ecm ed de ey ee SERS i i any ae "Hp supe Carne anti SD cnc so ater sco ace gad nat ise Cee be yee ‘Sivoo Unde sana) stone ee hare Searing ie pce ere ‘ ‘Sire sce dont sccm ‘Shtonemedie foneeestahastech trated a‘The Morel Haserd Problem: purcption constant mpi (thet egies 20) ists andwe EXeafown tn th puri contend witha)” The proper of he puma cotton be more coy eb we rennet fintordercontont 9) intbeallowng cto -nen[t-2h] foratietnmt 7 zee #0 FH] . ‘Not that fom hisequton tse osetia then ints tha (woul eto Beconsant oe sym Sc infrmaion ce: Howe this happens eine compay Druin canot besa thee ade gl om we te ‘Bh hand ie sy ote. Besa he eet poited ot TSSpsun wage willl bay thelowest poste forte The Kar Tuker condone mpow tht he muir said with she incentive compaiy const mute none. There Hi Sty postive Te ct that n> 0 he shadow pie ofthe resection Sct psn) measthathc eaten he rl arr probe inpie May postive cost the pica. The pcs poe ae cy {pute when norman on flr aye tam nen she a me Eerdaeston Sines he agenswage vai according othe lt obtained Ina scar the woe wl egret marth tio pi The rete tho quotin te mal wil be the ight han de of he ondton (3.7 tele and cme ule th dooriaor rst incre, whichin tor equestrian The rai 7p" Caled the iho eo inne he peso th hich the fot x Stas tht heeft wo The male theo quent te reer pire and hes hat het se wi Song ote wor redécon ntheiond tran nctenin the roby ti thee war when fc elt serene the ‘geen bere fn want the agen xe ih fot. Think Tnple ofa anion in whic (hin thet fre) the probate, ‘oun etinaeing Secu saeco icone eae Si ASaee ea dey push nor and arene cf Maaoahp Thies tyson ra mrtg epee SSUGEAC Eaton aed en apes ete ‘Sonn ries reine meron “Sfhod sumed the proctor ee theeqantonwoubeuachanged excep forthe sean a ts Namaste “ ‘The Moral Hazard Problem Aepending on the effort of result ae p/"=0.9 and p= 0.0, wil result, has the fllowing probable py" 001 and p!=0 8. Common sens ia ites thatthe principal wants to indace the agent tenet fot othe mus "sociate a premium with the abseration af ands punishment with the baeration of xe the principal being risk-neutral pays the agent according thereat, {soalyto ive im incentives. Hence se must consider finding sn equlibiam between the benefits tom insufing the agent, at inthe efficient soln, and those available rom him having the correct incentive. T satisfy this object nein the contrat she utes the only verifiable variable a soureof informa tion onthe agent behaviour The principal wes theres in his cae wth similar objective to tha of statistical inference. The benef of ntroding the ‘esl inthe contract isthe formation hat it provides onthe agente? “Anexamplemay elpto clan this pont. Astme that no variable levant totheagentsbehaviou are obserableandableto be incaded nthe contrat. ‘The weathers erable bat the agent cannot affect through his efort, and ‘thas no influence on the agent’ perormance, The principal could mike the nt wage contingent onthe resultof the random variable wether. Ie she Irested in doing thst No. By dings the only effec ito make the agent's ‘wage variable but varies according to something thatthe gent, bis be haviour, cannot influence. Therefore this variable hao vale at a meds of ‘ving the agent incentives but rater ony introduces more sk into the el Tionship. Ths increased risk means that the agent will egies higher wage in ‘order to participate andithas no effet whatsoever on his incentives, “This conclusion i altered when the results veriale variable and the weather hs some inloence overt (isthe case of agricultural proce). 18 Spite ofthe fact that the agent’ effort doesnot influence the weather, it oes Provide information onthe result nd so should be taken into acount in the ‘optimal contract. A good harvests generally a muchstronger signal of hight fortfthewenterbibeen ad than when the weather hasbeen eal The op timal payment an agricultural worker who obtainsa good harvest shouldbe greater for bad weather than fo good wenther ‘Afundamental aspect ofthe optimal scheme that the wage shouldnt de- end atallonthe vale that the principal plceson the rest. This ide tothe factthat ths valuation sindependentf the flor exerted and therefore not informatieast efor and does ot sere atan incentive forthe agent, Oa the 4‘The Moral Hazard Problem aver han, se resis valuable at an informative device at the ants ‘viou The oyofarereted ois information and wince nthe ‘ule longasageeter retained wheter fre alway op Tina hat the woe be inrening ithe rel No. or example stetons ‘tin which the principal wantsthe genta chose an effort wow pose ‘Snsquences a's hope ces ors dma fre, Both with eigifent jrobeblty and with a ntermedae real being very Hkh a is cae he {pina ora shoud pay more for lw rests ha or termed one. ‘The contracts objective not the optimal raksarng arrangement bt ratheritiea device to giveincentves "Theneenry condtion or aber resto ge aber wageisthat te dcresingin Insta this clled the monotonous tod quotient ‘rope tchould be pointed ou that iting conden. The hypothe Gl hst-odernochate dominance, 2, p< ps forall 1 Tedoes not guarantee he monotonous iketiood property However {hippest then w(x) incest Formal om condon (37) we obtain: wal which canbe rearranged get me) "Ween take thie value aa reference For the sich that pH P> law have w(x) Before continuing withthe duction on the characteristics ofthe solution 1 moral hazard, we note with espect tothe above arguments tht the rin: cipainfact does notcarry ost satis inferencesineitisshewho effectively hooses the agents fot by svg problem [P:) Hence se wllknow with erainty how the agent wl bebave Ifthe agent wages depend on the resltit, ie because this ste only way to influence his fort, not because the fort, hoe thatthe agent makes once the contract has bee signed isnot pe ‘tab “6 The Moral Hazard Problem 34 Solution Using the First-Order Approach ‘We have sen the characteristics ofthe optimal contract given a moral hazard problem when there re only two pose effort variables As we have note, {aking the agents effort asa continuous variable, for example ee (0,1) isnot «39, Problem [P] would imply a double maximization, which causes many technical dificule since one ofthe restrictions of [Pisa second man Jmization problem: equation (3.1). Thisincentive compat constait ap pears inan unmanageable form. In the ist studies on moral hazard mods, {his problem was overcome by subsitating the maximization problem of the agent bite ret-ordr condition (Holmstdm, 1979. This procedure icaled the frat onde approach: Te iden iso sbstitate etiction (3.1) in probe [P81 forthe equation: Eno monte )-v(e)=0 os) “The problem posed by this method of solving fr the optimal contri is that (8.8) aot vay equivalent othe agents maximization problem (3.1). The reason is tha it sony the necesary condition In general there ae more ‘forts that sty (28) han those that ati (31), sine it need not be con ‘ave problem. Tis isa serous setback since we are not discussing the proper- ‘sof the solution, but ater weareintedvcing thi equation aearesrction in constrained maximization probler, Therefore, we ae allowing ourslee ‘consider too many points, and we could end up choosing one that ot op ‘imal (or more details, see complementary material). ‘When the first-order approach cozy, the maximization problem ofthe rineipalis wx Spasms) Le tween. cad om w Enowwen-mory an Enwuwinr-vane on Lettng.be the muller forthe participation constrain andy be that ofthe incentive compatiblity constraint, the first-order condition of the Lagrangean wth respect tothe wages w(x) tellus that ”‘The Moral Hazard Problem =PAO+% pe) (wt) ) + m0 Owls) ‘hiss the necessary condition that the optimal contract mus satis. We ao now tit thiscondtioniefiient for ancl maximum since the Hess at a point that stisfes this condion is egative dete (he eason why isi arto that developed in note of thi chape) Rewriting the first-order con- Aon, we obtain the equality 1 le) TowGay7*** pce) Equation (39) implies tha, when > 09 hat when theresa el mora hurd problem, the condition of optimal isk shaingassoviatd withthe case ‘of symmetric information snot satisfied. Thatis.the wages willdependon the ‘euftbiained. The dependence of the wages on the esultin turn depends on the form ofthe function (2, (0 ‘Assume tht p/p, eis iereasing with = 1,» Jn this case the righthand sdeo (39) also increases with ands the same mast happen to thle and side, Given the characteristics ofthe uty anti. thisimplies that w is increasing in The condition tha the iklbod quotient iin ‘eising means that a good result signal that, wih igh probability, good “fort was exerted. Os smother words ismore il that when effort high, the ret good. The conclusion the same shat forthe two possible efor Finally comment on the effort thatthe principal demands ofthe agent under the optimal contract. Insite of the at that prober (P™) is generally, hot concave in effort, we Know that a necessary condition thatthe optimal {Mort not satiate ist-order condition of the Larangean with respect, toe Thisconditon is writen a: es) Ente twin) + | Epica wwe (0) (oe have use the fact that when we derive the participation constrain wth reapestt effort the same expression appears as for the incentive compat ity constraint which we know tobe 20). What is interesting about (3.10) i that shows the tade-off Between pris (the term on the let hand side of The Moral Hazard Problem ‘he equality) and cost (the right handside).-Thecosts areasoisted with ow anagents expected wage changes fo gen changes fort and he incentive ompatblty constraint, whose shadow rice given by the melpir Tes go back for moment to the tymmetric information framework, [Equation (28) is inthis ease, he necenary condition of problem (P!]that the optimal efor mast satis In fact had we obtained the necessary condi tion ret from the Lagrangean, the expression would have been (tis cay show that hs tion identi (29). Comparing 1) tnd G1) how that whe under mmc lafrton he ation ‘onsraint determines the optinl efit eve when theta or arr prblemitisthecetimpidby tenet opty constant chat be {mes the most inportant clement dating the fot coe demanded ithe opee ‘Wetec coins fit one apronch int hnyali Incomplementary materi? weilastat apical te poems hat his tethod an pow The wat oi the ble ie fo wor Wit tod in wh the nt pees gure ht te proc el {fined (nthesense hat iti posto spite estore cod without ‘sor ortfind sme ther way oso te probln, The fed con shat introns nh do fio fs