Moral Hazard and Target Budgets

Abstract

In this paper we investigate principal-agent problems with moral hazard and target budgets. The latter requires that the principal fixes a total budget for wages paid to agents regardless of their outputs realized ex post. Target budgets are relevant not just because they are exogenous institutional constraints in some cases, but they can also endogenously arise in other cases, especially when agents' performances are not verifiable and thus the principal needs subjective evaluations. Although target budgets impose an additional constraint, we show the irrelevance theorem that the principal is never worse off using target budgets when there are at least two risk-neutral agents. Even when all agents are risk averse, we also show that the similar irrelevance result asymptotically holds if the number of agents is sufficiently large. Furthermore, we characterize optimal contracts when the target budget becomes a tight constraint so that the irrelevance result cannot be applied.