Moral Hazard Model Research Articles

Foundation-controlled firms and CEO compensation

We explore the effects of foundation control on CEO incentive contracts. Unlike other blockholders, foundations do not consume the entirety of their cash flow rights, which attenuates the incentives of the controlling foundations to directly monitor the management. We present a simple model of moral hazard which predicts that foundation-controlled (FC) firms will resort to executive compensation as an alternative disciplining mechanism. Using a sample of listed Swedish family firms over the period of 2001–2014, we find that CEOs in FC firms are awarded more stock options compared to their peers in non-FC firms. The performance sensitivity of their option portfolios is also higher, but we do not find this to be the case for stock grants. Lastly, there is no conclusive evidence of differences in the levels of cash compensation. Our findings support the view that incentive contracts can substitute for large shareholder monitoring.

Contract Disclosure under External Scrutiny

ABSTRACT We examine the effects of mandating compensation disclosure on executive incentive contracts, earnings management, firm value, and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing an external monitor who allocates resources across firms to verify earnings management. With such scrutiny allocation, contracts exhibit externalities that create a coordination problem among principals. Contract disclosure enables principals to design the contract anticipating the monitor’s reaction. However, it may also exacerbate the coordination problem among principals because they do not consider externalities on other principals caused by the effects of their contract choices on the monitor’s scrutiny allocation. If internal controls are relatively weak, contract disclosure may make contracts more strongly contingent on reported earnings, increase earnings manipulation, and nevertheless increase social welfare. Contract disclosure improves firm value only if the scrutiny resources available to the monitor are not strongly constrained. JEL Classifications: C72; D62; G38; M43; M46.

Insurance Contracting with Adverse Selection and Moral Hazard

Most of the previous research in the asymmetric information problem treats adverse selection and moral hazard separately, though they may coexist and interact with each other. We build a principal-agent model to examine optimal contracts in a competitive insurance market facing adverse selection and moral hazard simultaneously. We apply the change-of-variable method and the Kuhn-Tucker conditions to solve the optimization programs. Our model yields richer separating Nash equilibria than pure moral hazard and pure adverse selection models, although separating Nash equilibria may not exist in some cases. It also retains some properties, for example, no full insurance and the positive correlation between insurance coverage and risk type, in those benchmark models. Our study on comparative statics indicates that, under some conditions and with some exceptions, the optimal indemnity and premium decrease with disutility from effort, increase with potential loss, and decrease with the initial wealth of the insured.

A dual approach to agency problems

This paper presents a dual approach to the standard model of moral hazard. We formulate the dual of the principal–agent problem under the assumption that the incentive constraint can be replaced by a local constraint (the first-order approach), to examine whether the relaxed agency problem yields a candidate solution. The dual formulation generates a convex conjugate, which transforms the agent’s utility from compensation into a dual functional. The dual problem features a simple convex structure, which enables us to perform a comprehensive analysis for the agency problem. We derive novel and more tractable conditions for existence and uniqueness of a solution to the problem with the dual elements. Furthermore, the approach to the dual problem provides illuminating insights into the previous nonexistence results.

BILATERAL MATCHING DECISION-MAKING IN PROPERTY TRADING PLATFORM: A METHOD CONSIDERING INTERMEDIARY MORAL HAZARD

Effective method of bilateral matching decision-making could drive the property transaction market more dynamic and healthier. In the property trade process, once intermediaries are conscientious, the portrait of matching parties are clearly described, a reasonable and satisfactory result can be got. However, the intermediary moral hazard and the loss of the description about the characteristics of matching parties can affect the matching result. By developing a method for a property transaction platform, this paper proposes a novel approach that considering intermediary moral hazard to improve matching efficiency. A mathematical model of intermediary moral hazard is performed, and then the price and other evaluation indicators of sellers and buyers are described by five different types of value forms. A multi-objective bilateral matching decision-making model that “minimizes the intermediary moral hazard in the case of the maximum benefits of the matching parties” is constructed and solved by the dictionary order method. A real case study of property trade platform is presented to illustrate how the proposed approach could be applied in practice. The results of this research indicate that the proposed approach is a useful tool for matching sellers and buyers under the intermediary moral hazard and has substantial practical application.

Optimal dynamic incentive mechanism design for construction and demolition waste recycling with Bayesian learning

A lack of a steady supply of high-quality construction and demolition (C&D) waste hinders the development of the recycling industry, and information asymmetry makes it difficult for a recycling company to determine incentive strategies for a collector. To address the problem, a dynamic moral-hazard model is formulated to obtain the optimal incentive mechanism. Bayesian learning is then introduced to update the estimation of a collector's private information. The results show that the collector is always motivated to voluntarily sustain a high-quality supply of C&D waste in the optimal mechanism. Additionally, the private information is gradually revealed by learning, which is conducive to controlling incentive costs. However, the collector is likely to misreport their information for higher profits, which reduces the learning accuracy and increases the incentive cost. Numerical analyses suggest that in response to misreporting, the recycling company should partially ignore the provided false information and extend the duration of each period of the contract over time, which can improve the learning accuracy. Therefore, this study helps to realize better recycling management from the perspective of interactive decision-making between the recycling company and the collector.

Agency Selling Format-Based Incentive Scheme in Cooperative Hybrid VLC/RF IoT System With SLIPT

Relay cooperation with energy harvesting provides a promising solution to alleviate coverage limitations and energy constraints in hybrid visible light communication (VLC)/radio frequency (RF) Internet of Things (IoT) system with simultaneous lightwave information and power transfer (SLIPT). In the hybrid system, the VLC service provider (VLCSP) seeks the cooperation of relay nodes (RNs) for information delivery to a certain end node (EN). However, considering the autonomous behaviors of the RNs, there are two challenging issues to address in facilitating relay cooperation: 1) selfishness and 2) information asymmetry. Hence, this article proposes a novel incentive scheme for relay cooperation based on an agency selling format. Unlike previous incentive scheme designs, first, the VLCSP charges the cooperating RN for energy harvesting per unit energy price. Second, once the information is successfully transmitted to the EN, the VLCSP pays a portion of future revenue as an agency payment to the RN, in a format seen as agency selling. By giving the VLCSP pricing power, it needs to design a mutually agreeable contract that includes a menu of unit energy prices and agency payments. Here, aiming to maximize the VLCSP’s expected utility, we apply a joint adverse selection and moral hazard model to formulate and optimize the contract design problem in the presence of information asymmetry. Then, the optimal contract solution is derived by using Lagrangian dual analysis. Besides, we present two extreme scenarios where only adverse selection or moral hazard model is applied. Numerical results illustrate that the proposed incentive scheme outperforms the considered benchmarks in terms of the expected utility of VLCSP and RNs, as well as the expected social welfare. We also demonstrate the incentive efficiency of our scheme

Relative Performance Evaluation and Strategic Differentiation

ABSTRACTI predict that relative performance evaluation (RPE) CEOs avoid strategic differentiation and increase the correlation of their firms’ returns with that of their peers. This prediction follows from a moral hazard model integrating strategic differentiation decisions: Differentiation enhances performance but exposes firms to risks not shared with peers, and the weakening RPE’s risk-shielding effect. Consistent with my prediction, I find evidence that changes in peer-group correlation are higher for RPE than non-RPE firms. This effect is more pronounced if benefits from differentiation are low, RPE benchmarks are industry specific, or RPE grants are large. Additional analyses provide direct evidence that RPE CEOs differentiate strategies less from industry-common strategies than non-RPE CEOs. To address endogeneity concerns, I present a two-stage least-squares approach exploiting variance in RPE usage induced by compensation consultants’ distinct styles. My analyses suggest strategic differentiation decisions to help explain why many boards do not completely filter peer performance from CEO compensation.Data Availability: All data are obtained from commercially available databases, including Compustat, CRSP, Execucomp, I/B/E/S, and ISS Incentive Lab.JEL Classifications: M12; M21; M41; M52.

Optimal technology design

This paper considers a moral hazard model with agent limited liability. Prior to interacting with the principal, the agent designs the production technology, which is a specification of his cost of generating each output distribution. After observing the production technology, the principal offers a payment scheme and then the agent chooses a distribution over outputs. We show that there is an optimal design involving only binary distributions (i.e., the cost of any other distribution is prohibitively high), and we characterize the equilibrium technology defined on the binary distributions. Notably, the equilibrium payoff of both players is 1/e.

Alternative Method to Resolve the Principal–Principal Conflict—A New Perspective Based on Contract Theory and Negotiation

Liquidated damages mechanisms have been analyzed from a legal perspective and applied to real-world contracts. Due to the lack of application of LDs to common agency theory, this research explores whether the liquidated damages mechanism can resolve principal–principal conflicts under common agency. We combine the moral hazard model of common agency with non-cooperative dynamic game theory to analyze the influence of the liquidated damages mechanism on the agent and principals under the condition of complete information and incomplete information. We find that liquidated damages are the key factors affecting the optimal contract between the principal and agent. Since the agent does not terminate the current contract, a principal–principal conflict arises when another principal wishes to enter into a new contract with the common agent. We find that the agent terminates the existing contract and signs a new one with another principal. The injured party requires liquidated damages from the breaching party. Therefore, they will negotiate the number of liquidated damages. Liquidated damages cause the bargaining game to generate a unique subgame perfect Nash equilibrium and sequential equilibrium. We prove that only when liquidated damages belong to a specific interval does a mechanism generating the Pareto optimal solutions to solve the principal–principal conflicts under common agency exist. A common way to resolve this conflict is ensuring that the minority is subordinate to the majority. For the first time, we study how the liquidated damages mechanism solves multi-principal conflict. This is another perspective that can be used to solve the conflict. Therefore, our paper expands the method of resolving the conflict and extends the theory of common agency; we first show the delegation process. Our research can be applied to various situations and provide a rational decision-making basis for participants.

Termination as an incentive device

In this paper, we study the conditions under which termination is a useful incentive device in the canonical dynamic principal‐agent moral hazard model of Sannikov (2008). We find that temporary suspension of the agent after poor performance dominates termination if the principal's outside option is low and the agent's outside option is moderate. In suspension, the agent performs tasks free of moral hazard and receives no compensation, which rebuilds his “skin in the game” and allows for incentives to be restored without terminating. If the agent's outside option is low, suspension is ineffective because it rebuilds the agent's skin in the game too slowly. If the agent's outside option is high, the profitability of the relationship with the agent is low, so the principal prefers to terminate rather than extend the relationship through temporary suspension. Because the optimal use of suspension versus termination after poor performance can be highly sensitive to the principal's and agent's outside options, similar jobs can have vastly different average job durations, purely for incentive reasons.

Accounting conservatism and relational contracting

This paper develops a positive role for accounting conservatism in fostering relational contracts between two agents in a two-period model of moral hazard. Building on Kreps (1996), the principal in our model designs a conservative measurement system and optimal contracts to create multiple equilibria that foster a team-based corporate culture. Accruals introduced by conservatism increase each agent's stake in the future of the relationship when it matters most—when it is going badly. This makes staying in the relationship worthwhile for the agents, even if they plan to play a low payoff equilibrium in the second period to punish first-period free-riding. In turn, this allows the principal to use lower-powered (and less costly) team incentives in the first period of the relationship. In contrast, deferred compensation increases each agent's stake in the future of the relationship when it is going well, making it less efficient in fostering relationships.

A Quantitative Model of Dynamic Moral Hazard

Abstract We develop an equilibrium model with moral hazard, which arises because some productivity shocks are privately observed by firm managers only. We characterize the optimal contract and its implications for firm size, growth, and managerial pay-performance sensitivity and exploit them to quantify the severity of the moral hazard problem. Our estimation suggests that unobservable shocks are relatively modest and account for about 10$\%$ of the total variation of firm output. Nonetheless, moral-hazard-induced incentive pay is quantitatively significant and accounts for 50$\%$ of managerial compensation. Eliminating moral hazard would result in about a 1$\%$ increase in aggregate output.

Understanding the Function of a Social Business Ecosystem

Social entrepreneurs face challenging situations in trying to expand and grow businesses with little investment and limited resources. Interactions and networks between social entrepreneurs, investors, and other stakeholders are indispensable in promoting social entrepreneurship. Together, they come to form a cyclical “social business ecosystem” (SBE), in which social entrepreneurs can finance their projects by paying “share transfer fees.” By using a theoretical/mathematical model in our method, this study examines the fundamental role of share transfer fees in an SBE. In particular, it establishes a moral hazard model that can explain important characteristics of an SBE. As main results, the study identifies conditions under which an SBE can mitigate the moral hazard of social entrepreneurs. The results suggest that SBEs work efficiently for relatively small social projects. This is consistent with actual cases of social business. Within this framework, this study also explores the practical implications of knowledge spillover; social entrepreneurs conduct SBEs more efficiently if they take advantage of knowledge spillover.

A General Framework for Robust Contracting Models

We study a class of models of moral hazard in which a principal contracts with a counterparty, which may have its own internal organizational structure. The principal has non‐Bayesian uncertainty as to what actions might be taken in response to the contract, and wishes to maximize her worst‐case payoff. We identify conditions on the counterparty's possible responses to any given contract that imply that a linear contract solves this maxmin problem. In conjunction with a Richness property motivated by much previous literature, we identify a Responsiveness property that is sufficient—and, in an appropriate sense, also necessary—to ensure that linear contracts are optimal. We illustrate by contrasting several possible models of contracting in hierarchies. The analysis demonstrates how one can distill key features of contracting models that allow their findings to be carried beyond the bilateral setting.

Cost-based pricing in government procurements with unobservable cost-reducing actions and productivity

ABSTRACT The effective and efficient implementation of government procurement improves social welfare, however, governments and policymakers struggle to refine contract arrangements. To investigate the optimal contract scheme, we analyze a hybrid model of moral hazard and adverse selection. We show that the contract price is higher when the firm’s cost–reducing capacity is unobservable than when it is observable. Moreover, the effect of the unobservability of the firm’s cost–reducing capacity becomes more severe as the information asymmetry between the government and the firm increases. We contribute to the literature by clarifying how information asymmetry leads to higher contract prices.

Is it really hard to motivate those who are not highly educated? Empirical evidence from a semi-parametric analysis

ABSTRACT In this study, we estimate the principal-agent model of moral hazard using a semi-parametric estimation method. We estimate the principal-agent model of moral hazard using longitudinal data on firms and managerial compensation collected from the database of Beijing Juyuan Ruisi Data Technology Corporation Limited, called RESSET. The estimated primitives in the contracting model show that most managers with high school and master educations have significantly higher costs of moral hazard than managers with university and doctor educations. Managers with high school and master educations are harder to motivate because they lack the knowledge to fulfill the delegated tasks.

A double moral hazard model for inter‐organizational knowledge sharing

AbstractIn inter‐organizational knowledge sharing, the firms share sensitive organizational knowledge to jointly solve a problem. However, the knowledge sender may conceal knowledge and the knowledge receiver may misappropriate the knowledge received from the sender. We formalize this situation using the double moral hazard framework and develop Stackelberg game models for symmetric and asymmetric information scenarios. First, we analyse the motivation for triggering double moral hazard. We find that by concealing knowledge, the sender cannot reduce the loss due to misappropriating knowledge. Second, we analyse the impact of improved punishment mechanism on the behaviours that trigger double moral hazard, and find that there exists a threshold policy with respect to monitoring effort to prevent double moral hazard. Third, we get the conditions under which the partner has the motivation to prevent the monitor from adopting a deception strategy.

Incentives, ability and disutility of effort

We generalize the disutility of effort function in the linear-Constant Absolute Risk Aversion (CARA) pure moral hazard model. We assume that agents are heterogeneous in ability. Each agent’s ability is observable and treated as a parameter that indexes the disutility of effort associated with the task performed. In opposition to the literature (the “traditional” scenario), we find a new, “novel” scenario, in which a high-ability agent may be offered a weaker incentive contract than a low-ability one, but works harder. We characterize the conditions for the existence of these two scenarios: formally, the “traditional” (“novel”) scenario occurs if and only if the marginal rate of substitution of the marginal disutility of effort function is increasing (decreasing) in effort when evaluated at the second-best effort. If, further, this condition holds for all parameter values and matching is endogenous, less (more) talented agents work for principals with riskier projects in equilibrium. This implies that the indirect and total effects of risk on incentives are negative under monotone assortative matching.

Is the moral hazard in the Chinese labour market serious? Empirical evidence from a semi-parametric analysis

ABSTRACT In this study, we extend the principal-agent model of moral hazard by incorporating different percentage effort choices made by the manager. Applying the semi-parametric estimation method, we estimate an extended principal-agent model of moral hazard using longitudinal data on firms and managerial compensation collected from the China Center for Economic Research database. The estimated compensation contracts confirm the non-neglected conflicts between management and shareholders, especially for managers in non-CEO or lower positions and in medium or large firms. Moral hazard is serious in large firms in the natural resources and manufacturing, as well as commercial product industries. Most managers’ compensation in these firms can not induce more than effort.