Moral Hazard in Teams Revisited

Summary This paper addresses the classic free riding question in a two-person managerial team Unlike pure moral hazard models, we assume that individual entrepreneurial abilitie also affects team output. Using a two-period model, we show that in an Alchian-Demsetz firm, even in a finite period game setting, effort levels of both team members higher than commonly perceived can be achieved. We argue that this is due to partial mutual observability between the team members. We then show that the existence of a self-enforcing mechanism in managerial teams alleviates free riding, and this is one reason why team structures persist. Comparison with classic capitalistic firms where group performance evaluation is abandoned yields the result that the optimal incentive piece rate should be lower in a team. This may explain the Jensen-Murphy puzzle.