Chapter 6 Hidden action problem George Hendrikse,Economics and Management of Organisations: Co-ordination, Motivation and Strategy,Incentives,Behavioural Hypothesis,Degree of Rationality,Complete,Bounded,Procedural,Opportunistic,Hidden action,Self Interested,Utopian,Figure 6.1: Decision order and complete information,The principal values a good result (p=30) more than a bad result (p=10), whereas the agent rather delivers a low effort (e=0) than a high effort (e=1).,The conflict of interests expresses itself in the fact that an increase in e, which is unattractive for the agent, means that p=30 becomes more likely, which is attractive for the principal.,This conflict of interest contrast may result in non acceptance of the contract by the agent, even though executing the transaction would create a surplus.,It is also possible that the agent does accept the assignment, but shows bad performance (Moral Hazard).,An efficient allocation of risk implies that the principal bears all the uncertainty, i.e. paying a fixed salary, because the principal is risk-neutral and the agent risk-averse.,Efficient performance incentives entail that the agent is stimulated to perform well. This happens in the model above, when the agent is rewarded on the basis of realised outcomes. This goes with uncertainty for the agent because the result is also determined by external circumstances.,Example: Tonsils and open-heart surgery A surgeon paid per open-heart surgery does twice as many operations than a surgeon with a fixed salary. A surgeon paid per tonsils surgery, does 15 times as many operations than a surgeon with a fixed salary.,Figure 6.7: Decision order and asymmetric information,An uncertain reward (0 with probability 1/3 and 9 with probability 2/3, which costs the principal 1/3*0 + 2/3*9 = 6) is valued lower by the agent than a certain reward (6 with chance 1 which costs the principal 6).,The uncertain outcome 0 with probability 1/3 and 9 with probability 2/3 (which costs the principal 6) is worth 2 for the agent, which is the same as a salary 4 with chance 1, which only costs the principal 4. The principal does not offer a fixed salary 4,4 because the agent would choose e=0 in this situation.,The loss of efficiency is caused by the conflict of interests and the risk-aversion of the agent. It is therefore not possible to establish an efficient allocation of risk as well as efficient performance incentives. (With one variable () you cannot solve two problems.),Determine the payoff maximising contract for the principal,Tool: Non-cooperative game theory,Solution concept: Nash equilibrium Subgame perfect equilibrium,Solution method: Backward induction,Incentive compatibility constraint,Structure the contract / payoffs, i.e. choose w(L) and w(H), in such a way that the choice of e=H results in a payoff for the agent which is not less than the payoff associated with the choice of low effort e=L.,Figure 6.8: Incentive compatibility constraint under asymmetric information,Participation constraint,The agent accepts an incentive compatible contract when the payoff of the contract for the agent, i.e. w(H) 2, is higher than what the agent can earn elsewhere, i.e. 0.,Figure 6.9: Participation constraint under asymmetric information,G,C,.,.,A,R,L,H,Principal,Principal,Contract,Choice contract w(9), w(16),Agent,Agent,Acceptance,Choice effort,0,0,0,0,9 w(9) w(9) 1,16-w(16) w(16)-2,Incentive intensity principle,Payoffs,Principal: P(e) - w Agent: w C(e) Where w = + z z = e + x,P(.): Revenue of principal C(.): Costs of effort e: effort w: wage z: output x: uncertainty : fixed wage : piece rate,Conflict of interest?,Yes, but why? P(e) w w - e,Incentive compatibility constraint, = C(e),Payoff maximising contract,* = P(e) / (1 + rVC”(e),Piece rate component is higher when: The agent is less risk averse (r); It is easier to measure the activities of the agent (V); The effort of the agent has more impact on the level of output (P(e); The agent has more discretion regarding the choice of activities (C”(e).,Extensions,Ratchet effect; Contractual externalities; Generating additional information.,Ratchet effect,Dynamic incentive scheme The tendency of performance standards to increase after a period of good performance is called the ratchet effect.,The ratcheting up of standards in response to good performance is not merely unfair, it can be unproductive. Basing standards on past performance penalises good performance and rewards bad. If workers foresee this possibility, very negative consequences may emerge.,There are two themes: Multiple activities; Inaccurate performance measurement.,Contractual externalities,What does it mean that performance cannot be measured at all? V = ,Equal compensation principle,If an agent is to allocate effort among different activities, then each must bring the same marginal return to effort. Otherwise, the agent will focus exclusivel