Hidden Action Problem Research Articles

Rationalizing risk aversion in science: Why incentives to work hard clash with incentives to take risks.

Scientific research requires taking risks, as the most cautious approaches are unlikely to lead to the most rapid progress. Yet, much funded scientific research plays it safe and funding agencies bemoan the difficulty of attracting high-risk, high-return research projects. Why don't the incentives for scientific discovery adequately impel researchers toward such projects? Here, we adapt an economic contracting model to explore how the unobservability of risk and effort discourages risky research. The model considers a hidden-action problem, in which the scientific community must reward discoveries in a way that encourages effort and risk-taking while simultaneously protecting researchers' livelihoods against the vicissitudes of scientific chance. Its challenge when doing so is that incentives to motivate effort clash with incentives to motivate risk-taking, because a failed project may be evidence of a risky undertaking but could also be the result of simple sloth. As a result, the incentives needed to encourage effort actively discourage risk-taking. Scientists respond by working on safe projects that generate evidence of effort but that don't move science forward as rapidly as riskier projects would. A social planner who prizes scientific productivity above researchers' well-being could remedy the problem by rewarding major discoveries richly enough to induce high-risk research, but in doing so would expose scientists to a degree of livelihood risk that ultimately leaves them worse off. Because the scientific community is approximately self-governing and constructs its own reward schedule, the incentives that researchers are willing to impose on themselves are inadequate to motivate the scientific risks that would best expedite scientific progress.

Agency Contracts, Noncommitment Timing Strategies and Real Options

Given that an owner lacks the ability to commit to his or her timing decisions under a manager’s hidden action, we consider the optimal design of the contract and the owner’s optimal timing decisions. Using a real options approach, we show that, compared with the full commitment case, a higher (lower)-quality project is launched later than (at the same time as) the first-best case, whereas the replacement of the manager is (is not necessarily) made later if the hidden-action problem is severe enough (is not severe enough). Severance pay may serve to minimize the compensation for the manager’s loss of corporate control.

Agency Contracts, Noncommitment Timing Strategies, and Real Options

Given that an owner cannot commit to her timing strategy under a manager's hidden action, we consider (i) how the owner's timing decisions to launch a project and to replace the manager or change a project are determined, and (ii) how the optimal compensation contract for the manager is designed. Using a real options approach, we show that, compared with the case in which the owner can commit to her timing strategy under the manager's hidden action, a higher (lower)-quality project is launched later than (at the same time as) the first-best case, whereas the replacement of the manager or change of the project is (is not necessarily) made later if the hidden-action problem is severe enough (is not severe enough). Unlike the folklore result of the standard moral hazard model, severance pay may serve to minimize the compensation for the manager's loss of corporate control if the hidden-action problem is not too severe.

Observing Unobservables: Identifying Information Asymmetries With a Consumer Credit Field Experiment

Information asymmetries are important in theory but difficult to identify in practice. We estimate the presence and importance of hidden information and hidden action problems in a consumer credit market using a new field experiment methodology. We randomized 58,000 direct mail offers to former clients of a major South African lender along three dimensions: (i) an initial “offer interest rate” featured on a direct mail solicitation; (ii) a “contract interest rate” that was revealed only after a borrower agreed to the initial offer rate; and (ii) a dynamic repayment incentive that was also a surprise and extended preferential pricing on future loans to borrowers who remained in good standing. These three randomizations, combined with complete knowledge of the lender's information set, permit identification of specific types of private information problems. Our setup distinguishes hidden information effects from selection on the offer rate (via unobservable risk and anticipated effort), from hidden action effects (via moral hazard in effort) induced by actual contract terms. We find strong evidence of moral hazard and weaker evidence of hidden information problems. A rough estimate suggests that perhaps 13% to 21% of default is due to moral hazard. Asymmetric information thus may help explain the prevalence of credit constraints even in a market that specializes in financing high-risk borrowers.

Hidden-Action in Network Routing

In communication networks, such as the Internet or mobile ad-hoc networks, the actions taken by intermediate nodes or links are typically hidden from the communicating endpoints; all the endpoints can observe is whether or not the end-to-end transmission was successful. Therefore, in the absence of incentives to the contrary, rational (i.e., selfish) intermediaries may choose to forward messages at a low priority or simply not forward messages at all. Using a principal-agent model, we show how the hidden-action problem can be overcome through appropriate design of contracts in both the direct (the endpoints contract with each individual router directly) and the recursive (each router contracts with the next downstream router) cases. We further show that, depending on the network topology, per-hop or per-path monitoring may not necessarily improve the utility of the principal or the social welfare of the system.

Adverse Selection, Seller Effort, and Selection Bias

1. IntroductionResearchers use several approaches to identify adverse selection.1 Genesove (1993) tests the proposition that, in a lemons market, prices inversely relate with observable seller characteristics that correlate with seller incentives to select goods adversely. Genesove examines the proposition in used automobile auctions. Chezum and Wimmer (1997) examine the proposition in thoroughbred racehorse markets, arguing that sellers with a high propensity to race horses should receive, on average, lower prices. Both Genesove (1993) and Chezum and Wimmer (1997) use data limited to market transactions. Wimmer and Chezum (2003) model adverse selection as a case of Heckman's (1979) sample selection bias and examine the correlation between errors in participation and price equations to study how third party certification could alleviate the effect of adverse selection in thoroughbred auctions.2In this paper, we extend the work of Genesove (1993) and Chezum and Wimmer (1997) and Wimmer and Chezum (2003) by characterizing adverse selection as a sample selection problem in a setting in which sellers possess (1) an informational advantage over buyers and (2) characteristics that correlate with both seller incentives to select goods adversely and the quality of goods produced. In such a setting, the relationship between prices and seller characteristics proves ambiguous, and researchers cannot easily disentangle adverse selection from quality effects. We show that Heckman's sample selection framework disentangles the correlation between a seller's characteristic and the effect of the selection decision on price from the correlation between a seller's characteristic and the quality of goods produced by a seller.The notion that the decision to sell goods relates to the quality of goods produced is not new. For example, Kim (1985) developed an adverse selection model in which car owners' maintenance and upkeep decisions affected the quality of used cars. Kim showed that allowing owners to affect the quality of goods could, under certain conditions, lead to an equilibrium in which the expected quality of used cars sold exceeds the expected quality of cars not sold. Similarly, we develop a theoretical model that extends a standard adverse selection specification by allowing owners (potential sellers) to improve a good's quality by expending unobserved effort. We show that owner effort only affects the adverse selection equilibrium when owners choose effort before they make the sell-retain decision.Owners decide whether to sell or retain a good once they observe their good's innate quality. Because buyers do not observe owner effort, the owner's dominant strategy is to expend zero effort on goods they will surely sell. Essentially, the model collapses to a standard moral hazard model, such as a fixed wage contract, in which employers cannot observe employee effort, and employees exert the necessary minimum effort to avoid dismissal. Because equilibrium effort equals zero, quality effects do not alter seller selection decisions and, therefore, the adverse selection equilibrium.Owners who must exert effort before they observe innate quality know only the probability that they will sell their goods and that the expected return to effort increases in the probability of retaining those goods. Because the probability of retention increases in seller incentives to select goods adversely, sellers who more likely select goods adversely also exert more effort. In this version of the model, no clear relationship exists between the expected quality of goods sold and the seller characteristics that Genesove (1993), and Chezum and Wimmer (1997) use to measure adverse selection. The model shows that uncertainty about whether a good will be sold partially solves the hidden action problem, in which owners underprovide effort and lessen the effect of adverse selection on markets.The notion that both adverse selection and moral hazard are important in markets affected by asymmetric information is well understood. …

Delegating to the Quango: Ex Ante and Ex Post Ministerial Constraints

This paper examines the contemporary formal theory of delegation in the environment of quasi-governmental, special purpose bodies (SPBs). Better known as quangos, these agencies present a challenge for the theory of delegation, since their tasks are often comprised of routine administration, such as the distribution of benefits and the collection of user fees, rather than more politically salient policymaking. Do (spatial) policy conflict and legislative capacity effect the conditions under which authority is delegated to quangos? What effect do good government ideology and legislative capacity have on the presence of ex ante and ex post control over quangos? These questions are theoretically framed by the hidden action problem particularly acute in the case of quangos. Theoretical predictions are examined with data from a study of Dutch public bodies by the Netherlands Court of Audit and as well as issue scales from the Manifesto Research Group. Multinomial logit statistical models produce evidence that though policy conflict and legislative capacity measures affect the probabilities of enacting both ex ante and ex post controls, their contributions to ex post measures, as expected in the presence of important hidden action incentives, are much stronger.

Disciplinary Observance and Sanctions on German and Danish Auditors

This paper presents the results of a comparative study on disciplinary observance systems of the auditing profession within two member states of the European Union: Germany and Denmark. Disciplinary observance is an important factor in reducing the hidden action problem, but could also be used by the profession to signal quality. In Germany, the Wirtschaftsprüferkammer is the supervisory body which oversees compliance with standards and professional duties. It is entitled to sanction the minor violations of duties by auditors. Only more severe types of misbehaviour are dealt with by courts. In Denmark, a special court (Disciplinæernævn) is concerned with disciplinary actions against auditors. The results of this study will demonstrate that audit regulations and in particular disciplinary laws remain basically national, despite efforts to harmonise auditing. This study identifies characteristics of disciplinary systems common to both countries and provides information on the functioning of both systems that may be useful in a number of ways. The results presented might initiate a more systematic comparison of disciplinary systems within member states of the European Union, which would enhance institutional knowledge of the European market for auditing services. This in turn could promote the process of achieving a single European market for auditing services and thus reduce market inefficiencies.

Long-Term Contracts, Short-Term Investment and Monitoring

term contracts, asymmetric information between investors and firms can make it impossible to implement profitable long-term projects. The paper characterizes the structure of optimal, renegotiation-proof contracts for unmonitored and monitored finance. Monitoring by investors, although itself subject to distorting incentive constraints, is shown to be able to overcome the short-term bias of investment and thus to lengthen the firms' planning horizon. I. INTRODUCTION An important question in the literature on corporate finance in the recent years has been whether the dependence on outside finance can force firms to undertake inefficient amounts of investment. Little work has been done, however, on the impact of outside finance on the quality of investment. The present paper studies this issue in the context of a question which has attracted considerable attention in the financial press and in the economic policy debate: can the dependence on outside finance lead a firm to undertake inefficient myopic investments?' To do this, the paper studies a dynamic model of financial contracting that allows one to characterize the choice of a firm's investment horizon. It points to information asymmetries as responsible for investment myopia, discusses the costs and benefits of monitoring as a reaction to it, and characterizes the optimal dynamic debt structure for unmonitored, as well as for monitored finance. According to standard financial theory, the market sees through the corporate veil and encourages the choice of efficient projects. In response to this, an important recent literature has developed more explicit theories of financial contracts and their role for the behaviour of imperfectly informed and strategically acting economic agents.2 This paper builds on this literature and analyses the problem of optimal financial contracting for a firm that wants to raise capital for a risky long-term investment project. The framework used to study the issue is a simple two-period contracting model, complicated by the interplay of hidden-characteristics and hidden-action problems on the side of the firm. More specifically, the probability distribution of project returns is assumed to depend on the intrinsic quality of the project, as well as on the investment horizon and effort chosen

Separating controllable performance from non-controllable performance: the case of optimal procurement contracting

Recent research has refined the notion that a manager's evaluation should be based only on controllable measures of performance. Introducing an explicit measure of non-controllable performance into the evaluation has been shown to reduce agency problems by allowing compensation to have a lesser dependence on non-controllable performance. While the agency literature on controllability has suggested the benefit of including non-controllable performance measures for evaluation, the literature has not focused on how the form of the actual contracts should be adjusted when more precise measures of non-controllable performance become available. In this paper, issues concerning contract form and controllability are addressed in the context of a procurement model based on that of McAfee and McMillan ( Rand Journal of Economics , 17; 1986). A linear incentive contract that depends on: (1) an imperfect signal of non-controllable costs; and (2) total costs, is shown to Pareto dominate a contract based on total costs alone. Thus, some theoretical justification for the use of cost escalation clauses is demonstrated. It is shown that as observability of the non-controllable costs increases, the form of the optimal contract moves closer to a fixed-price contract, and the expected utility of both the purchaser and potential suppliers increases. Hence, a complete ranking for a class of costless post-decision information systems is provided. Separating out some of the non-controllable costs allows better risk-sharing and lets the purchaser sharpen the trade-off between the incentives to deal with the hidden action problem versus the hidden information problem. In the limiting case, when the signal of non-controllable costs is perfectly informative, the optimal contract is shown to be a ‘fixed profit’ contract in the sense that the winning bidder's profits (not payment) are independent of the realization of non-controllable costs.