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A Note on Moral Hazard and Linear Compensation Schemes

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Date
2013-07-18
Author
Wang, XY
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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.
Type
Journal article
Subject
principal agent problems
moral hazard
linear incentive schemes
insurance
incentives
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https://hdl.handle.net/10161/13172
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Scholars@Duke

Wang

Xiao Yu Wang

Adjunct Assistant Professor of Economics
Xiao Yu Wang is an Assistant Professor in the Department of Economics at Duke University. Her major fields of interest are development economics and microeconomic theory. She uses a combination of theoretical and empirical tools to study the equilibrium emergence, evolution, and persistence of organizations and institutional structure, particularly in the unique environments of developing economies. She believes this is important for a better understanding of inequality, and that enrichi

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