CHAPTER 20 Contracts and Moral Hazards

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1 CHAPTER 20 Contracts and Moral Hazards CHAPTER OUTLINE 20.1 Principal-Agent Problem A Model Types of Contracts Efficiency 20.2 Production Efficiency Efficient Contract Full Information Asymmetric Information 20.3 Trade-Off Between Efficiency in Production and in Risk Bearing Contracts in Efficiency Choosing the Best Contract 20.4 Payments Linked to Production or Profit Piece-Rate Hire Contracts Contingent Contract Rewards Linked to a Firm s Success 20.5 Monitoring Bonding Deferred Payments Efficiency Wages After-the-Fact Monitoring 20.6 Checks on Principals 20.7 Contract Choice TEACHING TIPS Chapter 20 continues the discussion started in Chapter 19 on transaction costs. While it is not necessary to cover all of Chapter 19 before Chapter 20, it will be helpful if the class is familiar with at least the introductory portion of Chapter 19. 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 the best type of contract is. 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 for 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 through- 119

2 120 Part One\Teaching Aids out 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 their 1997 first round draft pick due to his salary demands, and he was placed back into the 1998 draft. 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 an individual level, efficiency wages should work, at a macroeconomic level, they should be inflationary. Especially in times of very low unemployment (such as ), 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 Contracts 1 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 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 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% 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), 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. 1 This section is based on: Weinraub, Bernard, 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; Abelson, Reed, The Shell Game of Hollywood Net Profits, New York Times, March 4, 1996:C1,C4.

3 Chapter 20\Contracts and Moral Hazards 121 Estimates of the share of movies that pay some net profits according to this method range from less than 5% to 20%. 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? 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 MATH 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 standpoint? Why would some firms pay fixed salaries? Which dealership is likely to employ workers that 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% to 50% 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?

4 122 Part One\Teaching Aids 6. Output of a firm is a function of labor input L, and monitoring M. the production function is Q = 16LM.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. 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? ANSWERS TO ADDITIONAL QUESTIONS AND MATH 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 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 that 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 are inappropriate, and hourly wages are used. 5. Assume that the size of the award is a function of the effort expended by the attorney. She has the incentive to maximize her percentage of the award, while you are attempting to maximize net proceeds. If the percentage is too low, the attorney does not have the incentive to invest large amounts of time in the case that might not increase the award by much. Her incentive would be to quickly

5 Chapter 20\Contracts and Moral Hazards 123 reach a settlement and move on to the next case. If the percentage paid is too high, the attorney may work harder to get a larger settlement, but the net proceeds are reduced. 6. To solve for the cost minimizing input ratio, set the ratio of marginal products equal to the input price ratio. In this case, it pays to have one supervisor for each worker. Q/ L = 16M.5 Q/ M = 8LM -.5 2M/L = 8/4 M = L 7. Because of the possible gains from shirking due to a lack of supervision, an hourly contract is least preferred by you as the homeowner. The person doing the weeding, however, would prefer such a contract, especially if there is uncertainty about how long the job will take. Payment of a fixed fee is preferable to an hourly rate, although there is risk for the homeowner that the person weeding will not do a thorough job given that compensation is the same no matter how long it takes. Payment by the pound may be a more efficient alternative, although neither party is likely to have good information about how long it takes to pick a pound of weeds. Under this scheme, the person weeding also has the incentive to put things in the basket that are not weeds, such as top soil (or worse yet, flowers!)

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