Subsidization of public transit service under double moral hazard

Abstract

This paper aims to explore incentive issues and characteristics of optimal contract schemes for subsidizing public transit services under double moral hazard, which refers to situations where both the regulator and the operator face incentives to engage in opportunistic behavior due to information asymmetry in the provision of public transit service. This specific aspect of the regulator-operator interrelationship has not been thoroughly investigated in the existing literature. To address this gap, we utilize principal-agent theory and develop a non-cooperative game-theoretic model to analyze the relationship between the regulator (the principal) and the operator (the agent). Through backward induction, we examine the first-best equilibrium (without moral hazard) and second-best equilibrium (under double moral hazard) solutions. Numerical analysis based on a linear contract reveals some key characteristics of the optimal subsidy contract arrangements. Our findings reveal that under double moral hazard, both the regulator and the operator only exert their second-best efforts. The result analysis shows that while higher incentives can reduce the effort required by the regulator, they can also induce the operator to work harder. The marginal effort utilities of the two parties have distinct impacts on determining the optimal sharing rule. Furthermore, we illustrate how the interaction dynamics of the efforts exerted by the two involved parties vary with the sharing rule. Our study extends the current literature by shedding light on the optimal incentive arrangements and contractual requirements for public transport subsidy contracts when considering the double moral hazard issue.