The Principal's Moral Hazard: Constraints on the use of Incentives in Hierarchy

Abstract

Pure incentive schemes rely on agent self-interest, rather than more coercive control, to motivate subordinates. Yet most organizations, and in particular public agencies, rely very little on pure incentive contracts. Most organizations rely on primarily coercive mechanisms of monitoring and sanctioning that many theorists have found objectionable about hierarchy. We identify a problem we denote as the principal's moral hazard constraint which can result in an inefficient reliance on monitoring and sanctioning: even when agent's behavior can be efficiently shaped by a straightforward incentives scheme, principal's self-interest may stand in way of implementing it. In these cases, bonuses large enough to produce efficient incentive effect are prohibitively expensive for principal. One way out of this trap - penalization of agent for poor performance - faces general legal restrictions in public workforce. Another - to form an ownership agreement with agent - is impossible due to ownership structure of government. This means that for a large class of control problems in agencies, and hierarchical control problems more generally, institutional designers must rely on more coercive monitoring-based mechanisms for controlling agents. While monitoring is often thought of as resulting from agent's moral hazard, it can just as reasonably be seen as resulting from principal's moral hazard.