Moral Hazard in the Presence of Suppliers and Competitors

Abstract

This paper examines the interdependence between a firm's moral hazard problem and its roles as a buyer of inputs and seller of final products. We demonstrate that to maximize profit a firm needs to adapt incentive contracts to variations in the competitive environment of the supplier market. Additionally, we show that moral hazard attenuates aggressive pricing of suppliers with market power and that this effect might even outweigh agency costs. We also show how the interaction between the firm-agent and the firm-supplier relationship affects a firm's decision to (de)centralize the tasks of cost reduction and input production. Our results are shown to be robust to variations in input and product market competition.