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A Note on Moral Hazard and Linear Compensation Schemes

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  • Xiao Yu Wang
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    Abstract

    This note identifies a moral hazard environment in which a piecewise linear compensation scheme is optimal. Both the principal and the agent have CARA utility, mean output is increasing in the agent's non-contractible input, and output is distributed according to a Laplace distribution, which resembles a normal distribution (e.g. it is symmetric about the mean), but has fatter tails. The key property of the Laplace distribution is that the likelihood ratio is a piecewise constant, where the discontinuity occurs at the mean. The value of this approach is twofold: First, a tractable, empirically-observed wage scheme emerges as the equilibrium in a simple static contracting model. Second, the optimal piecewise linear scheme cleanly separates insurance and incentive provision. The linearity at output levels away from the mean captures insurance, while the jump at the mean captures incentive provision. Hence, this model is well-suited for studying a wide variety of principal-agent problems in risky environments subject to moral hazard, such as the effect of risk and moral hazard considerations on employment relationships in developing economies.

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    Bibliographic Info

    Paper provided by Duke University, Department of Economics in its series Working Papers with number 13-23.

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    Length: 12
    Date of creation: 2013
    Date of revision:
    Handle: RePEc:duk:dukeec:13-23

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    Postal: Department of Economics Duke University 213 Social Sciences Building Box 90097 Durham, NC 27708-0097
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    Web page: http://econ.duke.edu/

    Related research

    Keywords: principal agent problems; moral hazard; linear incentive schemes; insurance; incentives;

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