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A Note on Moral Hazard and Linear Compensation Schemes

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  • Xiao Yu Wang

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.

Suggested Citation

  • Xiao Yu Wang, 2013. "A Note on Moral Hazard and Linear Compensation Schemes," Working Papers 13-23, Duke University, Department of Economics.
  • Handle: RePEc:duk:dukeec:13-23
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    Cited by:

    1. Xiao Yu Wang, 2014. "Risk Sorting, Portfolio Choice, and Endogenous Informal Insurance," NBER Working Papers 20429, National Bureau of Economic Research, Inc.

    More about this item

    Keywords

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

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development

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