Moral Hazard and Other‐Regarding Preferences

Abstract

The paper aims at obtaining new theoretical insights into organizational behavior by combining the standard moral hazard models of principal-agent relationships with theories of other-regarding (social or interdependent) preferences, in particular, inequity aversion theory. In the benchmark model, the principal and the agent are both risk neutral, while the agent is wealth constrained and hence the basic tradeoff between incentives and rent extraction arises. I show that other-regarding preferences interact with incentives in nontrivial ways. In particular, the principal is in general worse off as the agent cares more about the well-being of the principal. When there are multiple symmetric agents who care about each other's well-being, the principal can optimally exploit their other-regarding nature by designing an appropriate interdependent contract such as a "fair" team contract or a relative performance contract that creates inequality when their performance outcomes are different. The optimal contract depends on the nature of the agents' other-regarding preferences. The approach taken in this paper can shed light on issues on endogenous preferences within organizations, as suggested by sociologists and organizational economists.