Endogenous Correlation and Moral Hazard

Abstract : We study a contracting problem in which the agent’s action is two-dimensional. First, the agent controls the marginal distribution of a performance signal. Second, the agent manipulates the correlation between this performance measure and some exogenous signal like the business cycle. The model allows us to revisit the Informativeness Principle, which originally assumes that the agent’s action is one-dimensional and the information structure fixed. In the latter model, the principal is better off the higher the exogenous correlation is between the two signals. However, in the model with endogenous correlation, the principal may be better off incentivizing the agent to lower the correlation between the two signals. The optimal contract then appears less sensitive to exogenous signals than suggested by the standard approach. We examine the difference in the structure of the optimal contract in the two models. Several other applications of the new model are pursued as well.

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Optimal Monitoring Design

Abstract : This paper considers a Principal–Agent model with hidden action in which the Principal can monitor the Agent by acquiring independent signals conditional on effort at a constant marginal cost. The Principal aims to implement a target effort level at minimal cost. The main result of the paper is that the optimal information-acquisition strategy is a two-threshold policy and, consequently, the equilibrium contract specifies two possible wages for the Agent. This result provides a rationale for the frequently observed single-bonus wage contracts.

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Image Concerns in Teams

Abstract : The purpose of the paper is to analyze theoretically how social image concerns affect motivation problems in team production. One prominent feature of teams is mutual monitoring. Under close teamwork it is likely that team members can observe their effort each other, and they care about how their intrinsic motivation toward team performance and extrinsic incentives to do well for their own sake are evaluated by (some of) the other members. Image concerns can either attenuate or aggravate the free-rider problem. When the free-rider problem is mitigated by image concerns, increasing team size brings two positive incentive effects into the team. The first direct effect is that the agent cares more about his image concerns in larger teams because "more eyes" are observing his behavior. Second, even if the first effect is absent, the average team effort can still increase with team size because the weaker monetary incentives in larger teams raise the marginal reputational return to effort. Furthermore, these two effects interact with each other. I show that the average team effort per agent can even be increasing in team size. I next classify the agents into two categories, "insiders" and "outsiders" and show that replacing insiders by outsiders may have positive incentive effects. The results explain why increasing the number of independent directors or hiring a new CEO from outside ("new blood") can have significant and positive effects on firm performance.

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