Asymmetric information and Moral Hazard

Asymmetric information and Moral Hazard:

The incentive schemes discussed above will not work so well if there are asymmetric information of the hidden action type, i.e., the potential for moral hazard. This means that you cannot directly (or without incurring a too high cost of monitoring) directly observe the agent’s actions, or effort choice. This would not be a problem if there is perfect correlation between effort and output, in this case the contract could be written, not on effort, but contingent on the observed output. However, in many cases observed output is a noisy signal of true effort. I.e., the employee could have worked his butt off, but the weather or other elements beyond his control was against him, so output is low nevertheless. This causes him to bear a considerable income-risk by accepting, for example, a rental agreement, or the take-it-or-leave-it contract. If the employee is more risk averse than you are, this is an inefficient arrangement. The ideal in this case would be a fixed wage contract. The wage contract with piece-rates requires a lot of monitoring from your part. This may be more expensive than offering a fixed wage contract.

Sharecropping is a term which comes from the ancient practice of sharing of risk between a landlord and a tenant. Agricultural output is very dependent on the weather, and a share-cropping contract calls for the ten-ant/worker to be paid a fraction, α, of the realized output, plus a fixed wage, F. The worker’s maximization problem is,

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The solution for him is to set: αf′(e) = c′(e), which is clearly not optimal, he will supply to little effort since he only receives a fraction of the reward for an extra unit of effort. With asymmetric information share-cropping implies that the worker gets some incentive to exert effort (even though not the optimal one), but the risk is now shared with the landowner. This is sometimes a good compromise.

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