The Groves Scheme, Profit Sharing and Moral Hazard

Considered in this paper is the problem of intrafirm resource allocation. Two incentive schemes, the Groves scheme and profit sharing, have been presented in the literature as ways of dealing with this problem under conditions of asymmetric information. In the absence of effort aversion by division managers, it has been shown that truth-telling forms a dominant strategy equilibrium using the Groves scheme and a Nash equilibrium using profit sharing. The analysis in this paper allows for the problem of moral hazard (effort aversion) as well as the problem of asymmetric information. It is shown that for a deterministic case in which the headquarters seeks to maximize a measure of total profits gross of divisional rewards, a reinterpreted Groves scheme will yield a dominant equilibrium. At this equilibrium, the headquarters implicitly considers the division managers' effort levels as a cost to the firm. It is also shown that in the presence of moral hazard, profit sharing will not generally yield a Nash equilibrium. Furthermore, profit sharing may encourage the transmission of misinformation by a division manager so as to change the division's capital allocation and reduce the effort level subsequently selected by the manager.