Moral Hazard and Private Evaluation

There are many situations involving agency contracts where the principal has information about the agent’s performance that the agent doesn’t have — such complaints about the agent from third parties, or observations of the agent’s activities of which the agent is unaware.  Those are the sort of situations explored by William Fuchs of Chicago’s Graduate School of Business in a new piece called Contracting with Repeated Moral Hazard and Private Evaluations.  Here’s the abstract:

A repeated moral hazard setting in which the Principal privately observes the Agent’s output is studied. It is shown that there is no loss from restricting the analysis to contracts in which the Agent is supposed to exert effort every period, receives a constant efficiency wage and no feedback until he is fired. The optimal contract for a finite horizon is characterized, and shown to require burning of resources. These are only burnt after the worst possible realization sequence and the amount is independent of both the length of the horizon and the discount factor (δ). For the infinite horizon case a family of fixed interval review contracts is characterized and shown to achieve first best as δ → 1. The optimal contract when δ << 1 is partially characterized. Incentives are optimally provided with a combination of efficiency wages and the threat of termination, which will exhibit memory over the whole history of realizations. Finally, Tournaments are shown to provide an alternative solution to the problem.

[Frank Snyder]