Abstract
In many contracting settings, actions costly to one party but with no direct benefits
to the other (money-burning) may be part of the explicit or implicit contract. A leading
example is bureaucratic procedures in an employer-employee relationship. We study
a model of delegation with an informed agent, where the principal may impose money-burning
on the agent as a function of the agent’s choice of action, and show that money-burning
may be part of the optimal contract. This result holds even if action-contingent monetary
transfers are possible, as long as transfers from the principal to the agent are bounded
from below (as in limited liability or minimal wage requirements). In fact, the optimal
contract can involve a combination of both efficient monetary incentives and inefficient
nonmonetary incentives through money burning. Our model delivers some results novel
to the delegation literature. First, money-burning is more likely if the principal
is more sensitive to the choice of action than the agent. This is consistent with
the perception that there is more bureaucratization in large organizations. Second,
money-burning is more likely if the agent’s limited liability constraint is tighter
relative to his participation constraint. This implies that a higher minimum wage
distorts employment contracts towards using socially wasteful nonmonetary incentives,
leading to a Pareto inferior outcome as the agent is still held down to his reservation
value through increased money burning.
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