Chapter 26 Moral hazard

This chapter discusses moral hazard. The principal–agent relationship embodies a special form of moral hazard, which can be called “one-sided,” but moral hazard can also be “many-sided.” The paradigmatic model of many-sided moral hazard is the partnership in which there are many agents but no principal. The output of the partnership depends jointly on the actions of the partners and on the stochastic environment; each partner observes only the output (and his or her own action) but not the actions of the other partners or the environment. This engenders a free-rider problem. As in the case of principal–agent relationships, a partnership, too, may last many periods. The chapter presents the principal–agent model formally and describes some salient features of optimal principal–agent contracts when the relationship lasts a single period. In a large class of cases, equilibrium in the one-period game is Pareto-inefficient. This is a well-known problem in providing risk-averse agent insurance while simultaneously giving the agent the incentives to take, from the principal's perspective, appropriate actions. The chapter also discusses other properties of static contracts such as monotonicity of the agent's compensation in observed profits.