Standard Principal-agent Model Research Articles

Endogenous criteria for success

Economic agents are motivated to undertake costly actions by the prospect of being rewarded for successes and punished for failures. But what determines what a success looks like? This paper endogenizes the criteria for success in an otherwise standard principal-agent model with risk neutrality and limited liability. The set of feasible contracts is constrained by incentive constraints and possibly by a budget constraint. The first-order approach is not required to solve the problem. If the principal manipulates the criteria for success only to lower implementation costs, and depending on which type of constraint is more restrictive, the second-best action may be above or below the first-best action. In a class of problems where the principal's payoff depends directly on the criteria for success, the second-best solution features either more stringent criteria for success or a lower action (or both) than the first-best solution.

How Does Risk Tolerance Reflected in National Culture Affect Pay-Performance Sensitivity?

ABSTRACTThe standard principal-agent model predicts that, ceteris paribus, a negative relation exists between firm risk and CEO incentives or pay-performance sensitivity. We examine how a CEO’s risk tolerance (captured by national culture) affects pay-performance sensitivity using international data from 29 countries. We find that CEOs from countries with high (low) risk tolerance are associated with high (low) pay-performance sensitivity, suggesting that they require a low (high) risk premium. We contribute to the CEO compensation literature by introducing CEO risk tolerance, an overlooked factor, into CEO compensation contracts.

Stock-Based Compensation and Insider Trading with Liquidity Signal

We study a stock-based executive (CEO) compensation contract for the case where the insider receives a signal about the demand of liquidity traders in the stock market. The singleperiod model of Kyle (1985) is adopted for deriving the stock market equilibrium. Based on the equilibrium stock price, the optimal linear contract for executive compensation is obtained by applying a standard principal-agent model. Surprisingly, it is found that the firm’s liquidation value is not used in the optimal executive compensation contract in both our model and the benchmark model (where there is no signal about liquidity). We also make comparative statics for the equilibrium stock price and the optimal executive compensation contract with respect to exogenous parameters.

Salience Bias and Overwork

In this study, we enrich a standard principal–agent model with hidden action by introducing salience-biased perception on the agent’s side. The agent’s misguided focus on salient payoffs, which leads the agent’s and the principal’s probability assessments to diverge, has two effects: First, the agent focuses too much on obtaining a bonus, which facilitates incentive provision. Second, the principal may exploit the diverging probability assessments to relax participation. We show that salience bias can reverse the nature of the inefficiency arising from moral hazard; i.e., the principal does not necessarily provide insufficient incentives that result in inefficiently low effort but instead may well provide excessive incentives that result in inefficiently high effort.

Program design and heterogeneous treatment effects of payments for environmental services

Payments for environmental service (PES) programs have been increasingly promulgated worldwide recently to secure broader environmental benefits and provide financial assistance to environmental custodians. This study highlights the incentive design of PES and ecosystem providers' behavioral responses using a standard principal-agent model. Based on a theoretical model characterized by a screening game, I establish a hypothesis that as long as the PES conditionality is implemented and enforced effectively, ecosystem service (ES) providers more likely to participate in the scheme perform better in terms of environmental resource conservation. An empirical analysis in this study uncovers heterogeneous treatment effects in favor of the ES providers whose propensity scores for scheme participation are relatively high. This result lends strong support to the hypothesis that the strict conditionality embedded in the PES scheme dissuades potential participants at a high risk of noncompliance from participating the program, which helps enhance the PES additionality.

Value of audit for supply chains with hidden action and information

Outsourcing can provide firms with a competitive advantage by realizing the benefits of suppliers’ low labor, better quality and improved innovation. Yet, the supply chain managers have several concerns about outsourcing which are mainly due to lack of critical information regarding the actions of their suppliers. In this paper, we study the effectiveness of auditing the supplier’s hidden actions for the buyer (principal) when the supplier (agent) is privately informed about the extent of the supply risk. In order to accomplish this, we first extend the standard principal-agent model by considering a case in which the agent’s hidden action affects the extent of information asymmetry between principal and agent. By comparing the agency costs associated with the optimal menu of contracts with and without audit, we then completely characterize the value of audit from the perspectives of both buyer and supplier as well as total supply chain. First, the analysis of value of audit from the buyer’s perspective shows that the buyer can strictly benefit from auditing the supplier’s actions. Second, we find that not only the buyer but also the supplier can strictly benefit from an audit. Third, the audit enables the buyer to customize her contract offerings based on the reliability of the supplier. Finally, by analyzing the impact of problem parameters on the value of the audit, we identify the conditions under which an audit would be beneficial for individual supply chain parties as well as the overall supply chain.

Optimal incentive contract with endogenous monitoring technology

Recent technology advances have enabled firms to flexibly process and analyze sophisticated employee performance data at a reduced and yet significant cost. We develop a theory of optimal incentive contracting where the monitoring technology that governs the above procedure is part of the designer's strategic planning. In otherwise standard principal–agent models with moral hazard, we allow the principal to partition agents' performance data into any finite categories, and to pay for the amount of information the output signal carries. Through analysis of the trade‐off between giving incentives to agents and saving the monitoring cost, we obtain characterizations of optimal monitoring technologies such as information aggregation, strict monotone likelihood ratio property, likelihood ratio–convex performance classification, group evaluation in response to rising monitoring costs, and assessing multiple task performances according to agents' endogenous tendencies to shirk. We examine implications of these results for workforce management and firms' internal organizations.

Populism, the Backlash Against Ruling Politicians and the Possible Malfunctioning of Representative Democracy

The aim of this paper is to investigate the links between lack of trust in ruling politicians and the functioning of a representative democracy. Within a standard principal-agent model of democracy, we show how lack of trust by citizens as reflected by passive beliefs updating may lead to the malfunctioning of representative democracy. We highlight how de facto accountability crucially depends on out-of-equilibrium beliefs, and that this is indeed descriptive of a substantive feature of public opinion that affects the functioning of democracy. Specifically, we show that effective accountability needs more than simple retrospective voting, as it requires voters to believe in the existence of good politicians that always choose according to voters' interests, so that a deviation from bad policies can happen only because the leader is congruent. In this case, the unique equilibrium is an efficient one that maximizes voters' welfare. However, if, on the other hand, the citizens share an overall lack of trust in ruling elites, then there is another inefficient equilibrium, where even the congruent politician behaves badly because of the adverse but rational voters' behavior. This inefficient equilibrium does not depend on fake news or on distorted beliefs or, again, on voters' heterogenous preferences, since the voters' perfectly observe the quality of the policy implemented by the government, are fully rational and share the same interests. This result might contribute to explain the increasing negative perceptions on the working of democracy as due to a self-fulfilling equilibrium.

Uncertainty and Contracting in Organizations

We examine a multidivisional firm with headquarters exposed to moral hazard by division managers under uncertainty. We show the aggregation and linearity properties of Holmstrom and Milgrom (1987) hold under IID ambiguity of Chen and Epstein (2002). Due to uncertainty aversion, agents' beliefs depend endogenously on their exposure to uncertainty, either for their position in the organization (hierarchical exposure) or contracts (contractual exposure). Incentive contracts, by loading primarily on division cash-flow, lead division managers to be more conservative than headquarters, aggravating moral-hazard. By hedging uncertainty, headquarters design contracts that reduce disagreement, lower incentive provision costs, promoting effort. Because hedging uncertainty interacts with hedging risk, optimal contracts differ from those in standard principal-agent models. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative-performance compensation.

Effects of CEO miscalibration on compensation and hedging

Empirical evidence shows that CEOs are miscalibrated in that they underestimate market risk. We use a standard principal-agent model to investigate how CEO miscalibration influences compensation and hedging. CEOs hedge less as the level of CEO miscalibration increases. Consistent with the CEO miscalibration-compensation literature, the pay-performance sensitivity is positively related to CEO miscalibration. Further, our model predicts that the sensitivity of compensation to CEO miscalibration increases when it is more costly for miscalibrated CEOs to hedge market risk.

Ambiguity and Beliefs in the Principal-Agent Model

A Principal-Agent model in which the principal and the agent are ambiguity averse is examined. A novel role for the optimal contract is to induce a speci c partition of the state space for the agent as a means of manipulating the ambiguity he faces, thereby providing more efficient contracting. In contrast to the standard principal-agent model, the optimal contracts in this environment may be fairly simple. For example, the frequently observed step-function compensation schemes may be optimal when the agent is ambiguity averse. This insight has important implications for other fields of research, including security design and asset pricing.

The optimal timing of CEO compensation

We extend a standard principal-agent model of CEO compensation by modeling the progressive attenuation of information asymmetries about firm value by shareholders in continuous time. The dynamics of the stock price process are affected by the continuous accumulation of exogenous shocks, and by the progressive resolution of information asymmetries. The optimal timing of compensation is the point in time at which the stock price is most informative about the manager’s action. When exogenous shocks accumulate at a constant rate over time and information asymmetries are resolved at a decreasing rate, the optimal timing of compensation is the point in time at which these two rates coincide.

Managerial Ownership in Nursing Homes: Staffing, Quality, and Financial Performance.

Ownership of nursing homes (NHs) has primarily focused broadly on differences between for-profit (FP), nonprofit (NFP), and government-operated facilities. Yet, among FPs, the understanding of detailed ownership structures at individual NHs is rather limited. Particularly, NH administrators may hold significant equity interests in their facilities, leading to heterogeneous financial incentives and NH outcomes. Through the principal-agent theory, this article studies how managerial ownership of individual facilities affects NH outcomes. We use a unique panel dataset of Ohio NHs (2005-2010) to empirically examine the relationship between managerial equity ownership and NH staffing, quality, and financial performance. We identify facility administrators as owner-managers if they have more than 5% of the equity stakes or are relatives of the owners. The statistical analysis is based on the pooled ordinary least squares and NH-fixed effect models. We find that owner-managed NHs are associated with higher nursing staff levels compared to other FP NHs. Surprisingly, despite higher staffing levels, owner-managed NHs are not associated with better quality and we find no statistically significant difference in financial performance between owner-managed and nonowner-managed FP NHs. Our results do not support the principal-agent model and we offer alternative explanations for future research. Our findings provide empirical evidence that NH ownership structures are more nuanced than simply broadly categorizing facilities as FP or NFP, and our results do not fully align with the standard principal-agent model. The role of managerial ownership should be considered in future NH research and policy discussions.

Entrepreneurial orientation, risk and incentives: the case of franchising

The standard principal-agent model predicts a trade-off in contract design between the protection against risk and incentive motivations. Distinguishing two types of risks, we show that, contrary to this traditional view, the relationship between risk and incentives can be positive. In franchise contracting, this implies that the royalty rate decreases with the risk faced by the franchisee on the local market. Using a unique panel dataset combining French franchise and financial data, we address this issue empirically, alongside performance outcomes. The data support the hypothesis of a negative relationship between risk and the royalty rate, which contradicts the prediction of the standard agency theory. Furthermore, our estimations provide evidence that chain performance increases with an adjusted royalty rate. This paper has important implications for contract design, showing that with increasing local market uncertainty and low-risk aversion, franchisors should reduce the royalty rate.

Prudence and the convexity of compensation contracts

In a standard principal–agent model, we derive a new condition that relates the structure of the optimal contract to the agent’s risk preferences: The optimal contract is more convex than the likelihood ratio of the performance measure if and only if the coefficient of absolute prudence is larger than twice the coefficient of absolute risk aversion. With CRRA utility, this condition is satisfied if and only if relative risk aversion is less than one.

Optimal Incentive Contract with Costly and Flexible Monitoring

Recent advances in IT and data science give firms more flexibility to process, store and communicate the growing volume and variety of performance data at a reduced and yet significant cost. In this paper, we study the impact of this cost and flexibility on employee monitoring and the internal organization of firms. In an otherwise standard principal-agent model with moral hazard, we allow the principal to adopt any monitoring technology that classifies the agent’s raw performance data into finite categories, at a cost that increases with the fine-grainedness of the information that the induced performance signal carries. Through analyzing the trade-off between the compensation cost and the monitoring cost, we obtain characterizations for the optimal monitoring technology, such as information aggregation, strict MLRP, the fine-tuning of monitoring intensity across tasks according to the agent’s tendency to shirk, and the coexistence of individual and group evaluation systems among technologically similar firms. We apply these results to human resource management and suggest new explanations for long-lasting puzzles.

Loss averse agents and lenient supervisors in performance appraisal

A consistent empirical literature shows that in many organizations supervisors systematically overrate their employees’ performance. Such leniency bias is at odds with the standard principal-agent model and has been explained with causes that range from social interactions to fairness concerns and to collusive behavior between the supervisor and the agent. We show that the principal-agent model, extended to consider loss-aversion and reference-dependent preferences, predicts that the leniency bias is comparatively less detrimental to effort provision than the severity bias. We test this prediction with a laboratory experiment where we demonstrate that failing to reward deserving agents is significantly more detrimental than rewarding undeserving agents. This offers a novel explanation as to why supervisors tend to be lenient in their appraisals.

Relative Performance Benchmarks: Do Boards Get it Right?

Standard principal-agent models suggest that boards design incentive contracts that filter out common shocks in performance to motivate costly effort from the CEO ― a process entailing the judicious selection of benchmarks for relative performance evaluation (RPE). We evaluate the efficacy of firms' chosen RPE benchmarks and document that, relative to a normative benchmark, index-based benchmarks perform 14% worse in their time-series return-regression R2 and 16% worse in measurement error variance; firms choosing specific peers only modestly under-perform. Structural estimates suggest that, absent frictions, the underperformance of index-based benchmarks imply a performance penalty of 106-277 basis points in annual returns. Consistent with these estimates, firms choosing index-based benchmarks exhibit lower annual returns and ROA. Finally, reduced-form analyses suggest that the inefficient benchmarking is associated with governance-related frictions. Collectively, these findings provide new evidence on the explicit practice of RPE and its implications for corporate governance and firm performance.

Relationship between Risk and Incentives in Franchise Contracting

The relationship between risk and incentives in franchise contracting is still an unsolved issue in the literature. According to the standard principal-agent model, a trade-off emerges between the franchisee's protection against risk and incentive motivation. Contrary to this traditional view, we argue that the relationship between risk and incentives can be positive. In franchise contracting, this implies that the royalty rate decreases with risk. Using a unique panel dataset combining French franchise and financial data, we address this issue empirically and analyze the impact of a risk- and incentive-adjusted royalty rate on performance. The data support the hypothesis of a negative relationship between risk and the royalty rate, which contradicts the standard prediction of the agency theory. Furthermore, the estimation of random effect models provides evidence that chain performance increases with a risk- and incentive-adjusted royalty rate.

Prudence and the Convexity of Compensation Contracts

In a standard principal-agent model, we derive a new condition that relates the convexity of the optimal contract to the agent's risk preferences. This condition shows that the optimal contract is more convex than the likelihood ratio of the performance measure if and only if the coefficient of absolute prudence is larger than twice the coefficient of absolute risk aversion. With CRRA utility, this condition is satisfied if and only if relative risk aversion is less than one. We provide an economic intuition for the underlying tradeoff.