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 Hidden Action and Incentives  posted by  member7_php   on 4/7/2009  Add Courseware to favorites Add To Favorites  
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Hidden Action and Incentives

Bernard Caillaud
Ecole Ponts et Chauss´ee, Paris, and CNRS
Benjamin E. Hermalin
University of California, Berkeley

A common economic occurrence is the following: Two parties, principal and
agent, are in a situation—typically of their choosing—in which actions by the
agent impose an externality on the principal. Not surprisingly, the principal
will want to influence the agent’s actions. This influence will often take the
form of a contract that has the principal compensating the agent contingent
on either his actions or the consequences of his actions. Table 1 lists some
examples of situations like this. Note that, in many of these examples, the
principal is buying a good or service from the agent. That is, many buyer-seller
relationships naturally fit into the principal-agent framework. This note covers
the basic tools and results of agency theory in this context.

Table 1: Examples of Moral-Hazard Problems







Induce employee to take

actions that increase

employer’s profits, but

which he finds personally


Base employee’s

compensation on employer’s




Induce attorney to expend

costly effort to increase

plaintiff’s chances of

prevailing at trial.

Make attorney’s fee

contingent on damages

awarded plaintiff.



Induce contractor to

complete work (e.g.,

remodel kitchen) on time.

Give contractor bonus for

completing job on time.



Tenant Induce tenant to make

investments (e.g., in time or

money) that preserve or

enhance property’s value to

the landlord.

Pay the tenant a fraction of

the increased value (e.g.,

share-cropping contract).

Alternatively, make tenant

post deposit to be forfeited

if value declines too much.

 To an extent, the principal-agent problem finds its root in the early literature
on insurance. There, the concern was that someone who insures an asset might
then fail to maintain the asset properly (e.g., park his car in a bad neighbor-
hood). Typically, such behavior was either unobservable by the insurance company
or too difficult to contract against directly; hence, the insurance contract
could not be directly contingent on such behavior. But because this behavior—
known as moral hazard—imposes an externality on the insurance company (in moral hazard
this case, a negative one), insurance companies were eager to develop contracts
that guarded against it. So, for example, many insurance contracts have deductibles—
the first k dollars of damage must be paid by the insured rather
than the insurance company. Since the insured now has $k at risk, he’ll think
twice about parking in a bad neighborhood. That is, the insurance contract
is designed to mitigate the externality that the agent—the insured—imposes
on the principal—the insurance company. Although principal-agent analysis is
more general than this, the name “moral hazard” has stuck and, so, the types
of problems considered here are often referred to as moral-hazard problems. A
more descriptive name, which is also used in the literature, is hidden-action
problems.1 hidden action
As we’ve already suggested, the principal-agent model with hidden action
has been applied to many questions in economics and other social sciences. Not
surprisingly, we will focus on well-known results. Nonetheless, we feel there’s
some value added to this. First, we will establish some notation and standard
reasoning. Second, we will focus on examples, drawn from industrial organization
and the theory of the firm, of interest in the study of strategy. Finally, we
offer our personal opinions on the achievements and weaknesses of the moralhazard
model.   Tell A Friend