Endogenous Selection and Moral Hazard in Compensation Contracts

The two major paradigms in the theoretical agency literature are moral hazard (i.e., hidden action) and adverse selection (i.e., hidden information). Prior research typically solves these problems in isolation, as opposed to simultaneously incorporating both adverse selection and moral hazard features. We formulate two complementary generalized principal-agent models that incorporate features observed in real-world contracting environments (e.g., agents with power utility and limited liability, lognormal stock price distributions, and stock options) as mathematical programs with equilibrium constraints (MPEC). We use state-of-the-art numerical algorithms to solve the resulting models. We find that many of the standard results no longer obtain when wealth effects are present. We also develop a new measure of incentives calculated as the change in the agent\u27s certainty equivalent under the optimal contract for a change in action evaluated at the optimal action. This measure facilitates interpretation of the resulting contracts and allows us to compare contracts across different contracting environments

Endogenous Market Structures and Contract Theory

I study the role of unilateral strategic contracts for firms active in markets with price competition and endogenous entry. Traditional results change substantially when the market structure is endogenous rather than exogenous. They concern 1) contracts of managerial delegation to non-profit maximizers, 2) incentive contracts in the presence of moral hazard on cost reducing activities, 3) screening contracts in case of asymmetric information on the productivity of the managers, 4) vertical contracts of franchising in case of hold-up problems and 5) tying contracts by monopolists competing also in secondary markets. Firms use always these contracts to strengthen price competition and manage to obtain positive pro?ts in spite of free entry.Strategic delegation, Incentive contracts, Screening contracts, Franchising, Tying, Endogenous market structures

The trade-off between incentives and endogenous risk

Standard models of moral hazard predict a negative relationship between risk and incentives, but the empirical work has not confirmed this prediction. In this paper, we propose a model with adverse selection followed by moral hazard, where effort and the degree of risk aversion are private information of an agent who can control the mean and the variance of profits. For a given contract, more risk-averse agents supply more effort in risk reduction. If the marginal utility of incentives decreases with risk aversion, more risk-averse agents prefer lower-incentive contracts; thus, in the optimal contract, incentives are positively correlated with endogenous risk. In contrast, if risk aversion is high enough, the possibility of reduction in risk makes the marginal utility of incentives increasing in risk aversion and, in this case, risk and incentives are negatively related.Incentives, non-monotone contracts, single-crossing property.

The trade-off between incentives and endogenous risk

Standard models of moral hazard predict a negative relationship between risk and incentives, but the empirical work has not confirmed this prediction. In this paper, we propose a model with adverse selection followed by moral hazard, where effort and the degree of risk aversion are private information of an agent who can control the mean and the variance of profits. For a given contract, more risk-averse agents supply more effort in risk reduction. If the marginal utility of incentives decreases with risk aversion, more risk-averse agents prefer lower-incentive contracts; thus, in the optimal contract, incentives are positively correlated with endogenous risk. In contrast, if risk aversion is high enough, the possibility of reduction in risk makes the marginal utility of incentives increasing in risk aversion and, in this case, risk and incentives are negatively relatedIncentives, non-monotone contracts, single-crossing property.

Portfolio Choice when Managers Control Returns

This paper investigates the allocation decision of an investor with two projects. Separate managers control the mean return from each project, and the investor may or may not observe the managers’ actions. We show that the investor’s risk-return trade-off may be radically different from a standard portfolio choice setting, even if managers’ actions are observable and enforceable. In particular, feedback effects working through optimal contracts and effort levels imply that expected terminal wealth is nonlinear in initial wealth allocation. The optimal portfolio may involve very little diversification, despite projects that are highly symmetric in the underlying model. We also show that moral hazard in one of the projects need not imply lower allocation to that project. Expected returns are generally lower than under the first-best, but the optimal contract shifts more of the idiosyncratic risk in the hidden action project to the manager in charge of it. The minimum-variance position of the investor’s (net) terminal wealth would in most cases involve a portfolio shift towards the hidden action project, and there are plausible cases where this would dominate the overall effect on the second-best optimal portfolio when comparing with the first-best.Portfolio choice; diversification; optimal contracts

Endogenous Market Structures and Contract Theory. Delegation, principal-agent contracts, screening, franchising and tying

I study the role of unilateral strategic contracts for firms active in markets with price competition and endogenous entry. Traditional results change substantially when the market structure is endogenous rather than exogenous. They concern 1) contracts of managerial delegation to non-profit maximizers, 2) incentive principal-agent contracts in the presence of moral hazard on cost reducing activities, 3) screening contracts in case of asymmetric information on the productivity of the managers, 4) vertical contracts of franchising in case of hold-up problems and 5) tying contracts by monopolists competing also in secondary markets. Firms use always these contracts to strengthen price competition and manage to obtain positive profits in spite of free entry.Strategic delegation, Incentive contracts, Screening contracts, Franchising, Tying, Endogenous market structures

Community Participation, Teacher Effort, and Educational Outcome: The Case of El Salvador's EDUCO Program

Based on a principal-agent model, this paper investigates the organizational structure that made the El Salvador's primary school decentralization program (EDUCO program) successful. First, we employ the "augmented" reduced form educational production function by incorporating parents and community involvement as a major organizational input. We observe consistently positive and statistically significant EDUCO participation effects on standardized test scores. Then we estimated teacher compensation function, teacher effort functions, and input demand functions by utilizing the theoretical implications of a principal (parental association)-agent (teacher) framework. While the EDUCO school teachers receive piece rate, depending on their performance, wage payment is relatively fixed in the traditional schools. Empirical results indicate that the slope of wage equation is positively affected by the degree of community participation. This finding can be interpreted as the optimal intensity of incentive. Hence, teacher's effort level in the traditional schools is consistently lower than that in the EDUCO schools, indicating a moral hazard problem. Community participation through parental group's classroom visits seems to enhance the teacher effort level and thus increases students' academic performance indirectly. Parental associations can affect not only teacher effort and their performance by imposing an appropriate incentive scheme but also school-level inputs by decentralized school management. Our empirical results support the view that decentralization of education system should involve delegation of school administration and teacher management to the community group.economic analysis of social sector reform, the optimal intensity of incentive condition, moral hazard, education production function, fixed effects instrumental variable estimation

Explaining the evolution of pension structure and job tenure

Average and expected job tenure of workers has fallen significantly over the last two decades. Workers have also experienced a major shift in pension coverage. Traditional defined benefit pensions, designed to reward long tenure, have become steadily less common, while defined contribution pensions, which are largely portable, have spread. The link between job tenure and pension trends has not been closely examined, but it offers insights about both phenomena. This paper uses a contract-theoretic matching model with moral hazard to explain changes in both pension structure and job tenure; we discuss how a richer model with job-specific human capital subject to technology shocks would yield similar results. In our model, a decline in the value of existing jobs relative to new jobs reduces expected match duration and thus the appeal of DB pensions. We argue that these trends are linked to changes in the nature of new technologies. This explanation is consistent with observed trends in technological change, tenure, and pension structure. Our results suggest an additional consequence of technological progress that has not been closely studied.Pensions ; Retirement ; Defined benefit pension plans ; Defined contribution pension plans

Screening and advising by a venture capitalist with a time constraint

This paper proposes an intertemporal model of venture capital investment with screening and advising where the venture capitalist´s time endowment is the scarce input factor. Screening improves the selection of firms receiving finance, advising allows firms to develop a marketable product, both have a variable intensity. In our setup, optimal linear contracts solves the moral hazard problem. Screening however asks for an entrepreneur wage and does not allow for upfront payments which would cause severe adverse selection. Project characteristics have implications for screening and advising intensity and the distribution of profits. Finally, we develop a formal version of the "venture capital cycle" by extending the basic setup to a simple model of venture capital supply and demand