Incentive Contracts in Two-Sided Moral Hazards with Multiple Agents

doi:10.1006/jeth.1996.2253

Journal of Economic Theory

Volume 74, Issue 1, May 1997, Pages 174-195

https://doi.org/10.1006/jeth.1996.2253 Get rights and content

Abstract

The paper studies a contracting problem in which a principal enters in two-sided moral hazards withNindependent agents. There are no technological or informational linkages among theNagency problems. Despite this independence, optimal incentive schemes essentially eliminate the principal's incentive problem when team size is large enough. Reputation-like effects appear in a static setting through an improved aggregation of information about the actions of the principal. One implication of this result is that it is generally suboptimal to require an agent's compensation to depend only on his own outcome. Another implication is the existence of purely informational economies of scale to increasing team size. Thus, the concentration of otherwise unrelated transactions in a single “firm” creates wealth through a more efficient use of information about the Principal's actions. The paper also shows that extremely simple statistical contracts are approximately optimal in large teams. The outcome of such contracts is observationally indistinguishable from standard principal–agent contracts. This provides a theoretical justification for using standard principal–agent contracts in environments that involve two-sided hazard in a fundamental way.Journal of Economic LiteratureClassification Numbers: D21, D23.

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Cited by (11)

Quality incentive contracts considering asymmetric product manufacturability information: Piece rate vs. Tournament
2020, Computers and Industrial Engineering
Citation Excerpt :
Nalebuff and Stiglitz (1983) find that the tournament contract can achieve the first-best expected utility if the number of agents is sufficiently large. Some papers (e.g., Najjar, 1997; Tsoulouhas, 1999; Marinakis & Tsoulouhas, 2013) examine the role of tournament contracts in alleviating the double moral hazard, where the principal’s hidden action acts as a common shock over the performance of all the agents. The relative performance used in a tournament helps to filter the impact of the principal’s hidden action.
Product quality depends on not only the quality effort spent during the manufacturing process but also the product manufacturability determined at the product design stage. The manufacturer (he) may keep the product design and a part of production in house and outsource some production when he encounters a large unexpected demand. In this case, he may privately own the product manufacturability information (low- or high-type) and should propose an incentive-compatible contract to signal this information to the uninformed supplier. We first consider that the manufacturer outsources to one supplier and proposes a piece rate contract, with which the supplier is charged a quality penalty proportional to the amount of defective products supplied. In the separating equilibrium, the high-type manufacturer employs a smaller quality penalty rate and thus achieves a lower product quality under asymmetric product manufacturability information than under symmetric information. When the manufacturer outsources to multiple suppliers, he can employ a tournament contract, with which the quality penalty is based on the suppliers’ relative performance. In this situation, the equilibrium tournament contract under symmetric product manufacturability information is also the separating equilibrium contract under asymmetric information, hence resulting in the first-best quality and profit. We further find that the separating equilibrium exists and is stable while no pooling equilibrium is stable.
Incentives and management styles
2015, International Journal of Industrial Organization
Citation Excerpt :
Bhattacharyya and Lafontaine (1995) argue that a simple linear contract can arise as an optimal outcome under two-sided incentives. Al-Najjar (1997) studies a situation in which a principal contributes her own effort along with multiple agents. Kim and Wang (1998) show that two-sided incentives make the optimal contract less sensitive to the potential outcomes than the one under the standard one-sided incentive.
In a principal-agent framework, we explain different managing styles. In our model, there are two vertical tasks — an upstream task for improving the project's potential environment, and a downstream task for implementing the project. The downstream task must be done by the worker, but the upstream task can be done by either the manager or the worker. An effort for the upstream task is a hidden action of the party in charge of the task. The realized project environment is the manager's private information. We show that, when the upstream task is easy, the manager may assign the task to herself, even if her opportunity cost is larger than the worker's (a bias in favor of micro-management). When the upstream task is hard, by contrast, the manager may assign the task to the worker, even if her opportunity cost is smaller than the worker's (a bias in favor of macro-management). We also discuss distortions in the project output schedules in each case to show that the central trade-off is efficiency in task allocation versus efficiency in project output.
Dynamic risk-sharing with two-sided moral hazard
2007, Journal of Economic Theory
A group of risk-averse agents repeatedly produce a perishable consumption good; individual outputs are observable but efforts are not. The contracting problem admits a recursive formulation, and the optimal value function is the fixed point of a contraction mapping. When the agents can be punished to the full extent in a single period, every continuation contract of an optimal contract is itself optimal; the marginal utility ratio between one agent and another is a submartingale. The results imply that it is in general important to restrict an agent whose moral hazard constraint is binding from saving through another agent within the risk-sharing group. Limited commitment and long-run implications of optimal contracting are also examined.
Do tournaments solve the two-sided moral hazard problem?
1999, Journal of Economic Behavior and Organization
The paper analyzes the optimality of relative performance evaluation via two-part piece rate tournaments in incentive contracting with multiple agents and two-sided moral hazard. If the agents are risk-averse, it is shown that a tournament is optimal only when the following conditions hold: (i) there is common uncertainty inflicted on the activities of the agents that is not contingent on their actions, but can be contingent on the principal’s action; (ii) the principal sufficiently saves in transaction costs by employing a tournament; (iii) the number of agents is sufficiently large. Then the feedback effect of using a tournament to monitor the agents is that the principal’s moral hazard problem is relaxed when the principal takes a single action. It can also be relaxed when the principal can vary her actions with the agents but there are economies of scale in her activity. Absent common uncertainty, the optimum scheme is shown to be a fixed performance standard, rather than a tournament, but if the agents are risk-neutral, a tournament can still be optimal provided that (ii) and (iii) hold.
Linear Contracts and the Double Moral-Hazard
1998, Journal of Economic Theory
This paper studies the characteristics of optimal contracts when the agent is risk-averse in the double moral-hazard situation in which the principal also participates in the production process. It is already known that a simple linear contract is one of many optimal contracts under the double moral-hazard when the agent is risk-neutral. We find that the agent's optimal incentive scheme in this case is unique and non-linear, but less sensitive to output than would be designed under a single moral-hazard. We also find that the linear contract is not robust in the sense that the above unique and non-linear contract does not approach the linear contract as the agent's risk-aversion approaches zero.Journal of Economic LiteratureClassification Number: D82.
Public procurement policies of Nigeria and Ghana: an analysis of the administrative challenges in achieving value for money
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^☆: This is a revised version of an earlier paper titled “Incentive Contracts and Statistical Inference in Large Team Moral Hazards.” I thank Michael Riordan, Dilip Mookherjee, Doug Allen, John Ledyard, two referees of this journal, and seminar participants at Laval, Northwestern, Princeton, Penn, and MIT for their comments. This research was partially funded by a grant from the Social Sciences and Humanities Research Council of Canada. All remaining errors and shortcomings are my own.

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Regular ArticleIncentive Contracts in Two-Sided Moral Hazards with Multiple Agents☆

Abstract

Games Econ. Behav.

J. Econ. Theory

Reputation, product quality and warranties

J. Econ. Management Strategy

MEDS Department, Kellogg GSM

Double-sided moral hazard and the nature of share contracts

RAND J. Econ.

Regular Article
Incentive Contracts in Two-Sided Moral Hazards with Multiple Agents☆