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Chapter 19
Contracts and Moral Hazards
Chapter Outline
19.1 Principal–Agent Problem
A Model
Types of Contracts
Efficiency
Application: Selfish or Selfless Doctors?
19.2 Production Efficiency
Efficient Contract
Full Information
Fixed–Fee Rental Contract
Hire Contract
Revenue-Sharing Contract
Solved Problem 19.1
Profit-Sharing Contract
Asymmetric Information
Fixed–Fee Rental Contract
Hire Contract
Revenue-Sharing Contract
Profit-Sharing Contract
Application: Contracts and Productivity in Agriculture
19.3 Trade-Off Between Efficiency in Production and in Risk Bearing
Contracts and Efficiency
Lawyer Gets a Fixed Fee
Solved Problem 19.2
Lawyer Is Hired by the Hour
Fee Is Contingent
Choosing the Best Contract
Application: Music Contracts: Changing Their Tunes
19.4 Monitoring to Reduce Moral Hazard
Bonding
Bonding to Reduce Shirking
Solved Problem 19.3
Problems with Bonding
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Deferred Payments
Efficiency Wages
After-the-Fact Monitoring
Application: The Mortgage Market Meltdown
Solved Problem 19.4
19.5 Contract Choice
19.6 Checks on Principals
Application: Layoffs Versus Pay Cuts
Teaching Tips
Chapter 19 continues the discussion started in Chapter 18 on information asymmetry. While it is not necessary
to cover all of Chapter 18 before Chapter 19, it will be helpful if the class is familiar with at least the
introductory portion of Chapter 18. However, the material is not difficult and need not be saved for the end
of the semester if you are interested in including it earlier. For example, one logical place to discuss
principal–agent problems is while covering the factor markets (Chapter 15). By doing so, you can contrast
labor markets at the aggregate level with labor contracts at the individual level.
One of the keystones of the material in this chapter is incentive compatibility. You might suggest to the
class that whenever they are evaluating an individual level transaction, one of the prerequisites to sound
analysis is to check the incentives of the buyer and the seller. For example, does the seller expect repeat
sales in which reputation will be important, or are all sales to one-time customers who won’t have much
recourse or ability to spread negative information if ripped off? Do the buyers have any incentive to claim
that they are part of one group (e.g., healthy individuals) when they are not, as in the case of insurance?
By beginning the discussion in this way, you should be able to lead the class directly to the importance of
information and the opportunity for moral hazard problems to arise when information is asymmetric.
The optimal contract type depends on the level of uncertainty and symmetry of information between buyer
and seller. Possible arrangements include piece rates, fixed fees, hourly rates, and contingent fees. You
might present the class with a number of transactions and ask them to decide what is the best type of contract.
They may find that in many cases, the seller would prefer one type of contract and the buyer another, and a
compromise between efficiency and risk bearing must be sought. The text includes such an example of Pam,
who is injured in a car accident, and her attorney, Alfredo. Another example is a professional athlete and
team owner. The athletes would like the contract to be guaranteed so that, no matter what the performance level
is, he or she receives payment. Employers (teams) would prefer to pay employees based on performance. The
advantage of sports examples is that there is a steady stream of stories throughout the year of player
negotiations that have reached stalemates over contract structure. An extreme example is professional baseball,
in which top draft picks demand large contracts (typically in excess of $8 million) with a good portion
guaranteed as a “signing bonus.” These demands come despite the fact that the drafted players have never
played at the major league level. Because of the uncertainty involved (many top drafted players never
succeed at the professional level in baseball), some teams have been very reluctant to meet players’ demands.
For example, the Philadelphia Phillies never signed J.D. Drew, their 1997 first round draft pick, due to his
salary demands, and he was placed back into the 1998 draft and drafted by the St. Louis Cardinals.
Another topic that can generate good class discussion is monitoring. Under some circumstances, employees
don’t need to be monitored. If incentives are compatible, then the employees’ maximization problem is
structured such that by maximizing their own utility, profits are maximized for the principal. In cases
where this is not possible and shirking may occur, monitoring is required. An interesting topic to discuss
here is the efficiency wage debate, as this provides a link to macroeconomics. Logic dictates that while at
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an individual level, efficiency wages should work, at a macroeconomic level, they should be inflationary.
Especially in times of very low unemployment (such as 1996–2000), if firms are paying workers some
level above the reservation wage, wage inflation should occur. Unfortunately, empirical confirmation of
this effect is far from certain.
Additional Applications
Movie Contracts1
The movie Forrest Gump was the third highest grossing film of all time, with $660 million in ticket sales.
Its star, Tom Hanks, got $31 million from a percentage of the revenue. Yet its author, producers, and
screenwriter, who were promised a percentage of the reported profit, got nothing in 1994. Thanks to the
miracle of Hollywood accounting, Viacom Inc., the studio distributing the movie, told these people that
the hit film Forrest Gump “lost” $62 million in 1994. At Viacom’s annual meeting in 1995, its chief
executive, Frank Biondi, admitted, “Of course” Gump was profitable, in response to a shareholder’s question.
How can Viacom reconcile those conflicting reports on profitability? Most major studios maintain two
methods for telling their financial stories. One set of books, financial accounting, uses Generally Accepted
Accounting Principles (which accountants use to keep books for tax purposes if they don’t want to end up
in jail) and is shown to studios’ corporate overlords and shareholders. A second set of books, contractual
accounting, is used when one of the big studios commits itself to dividing the proceeds from a film among
actors, directors, writers, animators, producers, and other creative people after the expenses, from distribution
fees to star salaries, have been paid.
This contractual profit bears little resemblance to either accounting or economic profit. To calculate it,
the studio subtracts from gross receipts the distribution fee (30 percent in the United States and Canada
and more abroad), promotional expenses, cost of prints, overhead charges (that are calculated by an
arbitrary rule based on variable costs), and direct costs of production (including payments out of revenues
to stars). The long and the short of it is that the studio does not have to disclose true costs in making these
calculations. Moreover, this measure of profit apparently is smaller than other more standard measures.
Why do stars get a share of revenue, while lesser–known actors, writers, directors, and others agree to
take a share of net profit? Presumably, the stars have more bargaining power. They will certainly be paid
because revenues are positive even if the net profit measure is not. The studios offer others relatively less
lucrative contracts based on these contractual profits, so they receive these contingent payments only if
the film is extremely successful. In other words, the studio pushes much of the risk onto these people.
Estimates of the share of movies that pay some net profits according to this method range from less than 5
percent to 20 percent. According to the studios, even blockbuster movies such as Batman, Coming to
America, Indecent Proposal, and J.F.K. lost money, at least initially.
1. Suppose the method of keeping two sets of books was disallowed. Would studios prefer to
compensate these individuals using flat fee contracts or share of revenue contracts? What would the
workers prefer? How would level of risk aversion affect the choices made by each?
2. With contracts written as described above, who should the studio attempt to sign to a movie contract
first, the stars or the producer? Why?
1This section is based on Bernard Weinraub, “Profits Elude ‘Gump,’ Studio Says,” San Francisco Chronicle, May 25, 1995:
E1; “Who Ate All the Chocolates?” New York Times, May 28, 1995: 3:1; “Buchwald, Paramount Settle Suit,” San Francisco
Chronicle, September 13, 1995:E4; Reed Abelson, “The Shell Game of Hollywood ‘Net Profits,’” New York Times, March 4,
1996: C1,C4.
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Discussion Questions
1. In the savings and loan (S&L) disasters of the 1980s and early 1990s, S&Ls engaged in risky
investments that led to bankruptcies (see the application discussed in the chapter). Federal insurers
incurred huge losses. Where did this money go? Was it truly “lost”?
2. In earlier civilizations, neighboring countries often exchanged hostages (including close relatives of
the king) to prevent wars. How does this compare to the use of performance bonds?
3. How is “reputation” like a performance bond?
4. A book author and a publisher sign a contract. Which is the agent and which is the principal? Does it
matter for analysis purposes?
5. Why do we observe contingent contracts for lawyers who collect a fee only if they win? Under what
circumstances do lawyers work for fixed fees instead?
6. Analyze a typical professional athlete’s contract in terms of the concepts in this chapter.
7. Why would the NFL have a lower percentage of guaranteed contracts than professional baseball?
8. Should college professors be paid based on the number of students enrolled in their classes?
Additional Questions and Problems
1. Is it in the best interest of a basketball team to have player contracts laden with individual incentives?
Why or why not?
2. Some brands of hand tools are guaranteed forever. If the tool ever breaks, the customer can return it
for a replacement, no questions asked. Why would they make such a claim? Why might power tools
be excluded from this guarantee? What moral hazard problem does the guarantee create?
3. Most auto salespersons are paid the majority of their earnings in the form of commissions on sales. At
some dealerships, however, they make it a point to inform customers that salespersons are paid
salary. Which payment structure is more incentive compatible from the firm’s standpoint? Why
would some firms pay fixed salaries? Which dealership is likely to employ workers who are more risk
averse?
4. If most car salespeople are paid by commission, why aren’t the workers in the service department
paid the same way? Why not also pay factory workers using the same scheme?
5. Suppose you are involved in a traffic accident that is judged to be the other driver’s fault. You are
injured in the accident, so you speak to an attorney regarding a possible lawsuit. The attorney announces
that she is willing let you choose you own fee structure: “I will charge you anywhere from 5 percent
to 50 percent of the settlement value to handle your case, and you may choose the percentage at the time
I am hired.” What are the pros and cons of choosing a high or low percentage?
6. Output of a firm is a function of labor input L, and monitoring M. The production function is
Q = 16 LM0.5. The cost of labor is $8 per unit, and monitoring can be purchased for $4 per unit. What
is the optimal mix of labor and monitoring?
7. Suppose your doorbell rings and it is your neighbor’s son, offering to weed your flowerbed, which
goes all the way around your house. You would like to have it weeded but cannot stay to supervise.
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Should you offer to pay by the hour, pay a fixed fee, or pay by the weight of the weeds picked? What
is the person doing the weeding likely to prefer?
8. Why do some firms offer a money–back guarantee for their goods? What is the moral hazard
implication of this policy?
9. In 1997, the old welfare program, which provides income support for low-income families, was
replaced by the Earned Income Tax Credit program, which gives earning subsidy for low-income
working families. Why may this new program help to reduce the moral hazard problem of long-term
welfare recipients?
Answers to Additional Questions and Problems
1. The advantage of individual incentives is that the player gains personally by performing better on
the field. When players perform better, the team typically performs better. For example, with
running backs in football, the farther they run, the more likely it is that their team will score. The
disadvantage of individual incentives is that in team sports, an individual must sometimes make
sacrifices for the good of the team. For example, a basketball player may have an incentive in his
contract based on scoring a certain number of points. Such an incentive would lead him to take
unwise, low percentage shots, when a teammate might be open for a pass that would lead to an
easier basket.
2. With many hand tools, such as a hammer or a pair of pliers, it is very difficult for the customer to tell
the quality of the tool by simple inspection, or even in a short–term, in–store test. The quality of these
products is revealed over time. In order to reduce the risk to customers that they will have a tool fail
that they would then have to pay to replace, the firm offers free replacement. Makers of inferior tools
would be unwilling to make such an agreement as it would not be cost effective. Power tools are typically
excluded due to the limited life of electric or gasoline motors and other moving part assemblies. The moral
hazard problem that this creates is that once a customer owns a tool with a lifetime guarantee, he or
she has no incentive to properly care for the tool or to not use it in a way that will likely lead to breakage.
3. Paying by commission is a more incentive–compatible contract for the auto dealer. This way,
salespeople have the incentive to actively work while on the sales floor and attempt to get every
possible customer to purchase a car for the highest possible price. If commissions are paid on a per–car
basis, the incentive to get the customer to pay a high price is reduced. Some dealerships pay fixed
salaries to their sales force in response to customer dissatisfaction with high pressure sales techniques
from commission-based firms. Risk–averse workers are likely to prefer a fixed salary, even if the
expected salary from commissions is higher than the fixed salary.
4. Workers in the service department are not paid based on commission due to the asymmetry of
information between the mechanic and the consumer, and the resulting possibility for moral hazard in
the form of ex-post opportunism. Once the mechanic has the car, the more he or she repairs (whether
it needs it or not) the more he or she is paid on a commission scheme. Because consumers are aware
of the information asymmetry problem, they would be very unlikely to choose a dealership for repairs
if mechanics were not paid a fixed salary. Factory workers who build the cars work on production
lines, and so are not in control of the volume of total output produced. Nor are they in control of the
quality of work done by others. Because they are also not in control of the pace of their own work,
piece rates would be inappropriate, and hourly wages are used.