Responsibility Center Budgeting as a Mechanism to Deal with Academic Moral Hazard

A Faculty chooses a level of costly effort in generating revenue for the university. The revenue is deployed in the pursuit of academic excellence in research and teaching. The effort is not observable by the central Administration and the amount of revenue generated from given level of effort is uncertain. The Administration and Faculties are assumed risk averse. I show that when effort is observable, or there is no uncertainty, or the Faculty is not risk averse, pure Responsibility Center Budgeting (RCB) is efficient and optimal from the perspective of the Administration. The intuition for this is provided by pure RCB solving the incentive problem and leading to the right effort level by making the Faculty the residual claimant. Once the Faculty is risk averse I show partial RCB is optimal. A problem with pure RCB is that the Faculty holds all the revenue risk. Partial RCB then provides a balance between providing the right incentives to the Faculty and the Administration providing partial insurance to the Faculty. In my simple model I show that we move further away from pure RCB, the more uncertain the environment, the more risk averse the Faculty, and the less risk averse the Administration.