2

Thc Theor. r of Incent ives:

Multi-Agcnt Moclcls

Jean-J ac4ues La ffoul a nd Dav id ~ lart imort

5th Ju ly 2005

Chapter 7
Multiagent Mode ls with Moral
Hazard
So far we ha\'c concentratoo our analysis on ach·crsc sdcction models. ll owcvcr símik1 r
issucs a risc in mora l hazard modcls.
Scction 7.1 charactcrizcs in a principa.I two-agr nt modcl. with t wo va.hws of r ffort
a 11d two '11lue> of output , t he optima! cont ract when agent co111pctc <i ncl thc tochnologie;
thcy cach use are stochast.ically de pcnd 11t. Se1.:tiou 7.2 shows that, if the production of an
11gP11! is a suffi irnr st at L't i . for t he \'CCt.'lr of out puts wil h n °"p<'<1. to his own dforl lr ' '<ºI.
his paymcnt at the optima! rontract is inclepcndcnt of thc othcr agent 's pe r~ rn1an(' .
T ite non-coopcra ti,·c outcomc of SC<:üon 7. 1 is sh wn iu S t.ion 7.3 to domínate, from the
poim of vicw of the principal , Lhc opti nwl rontract. whcn agents side-contract (or rolludc),
i[ agcnls do not observe ca.ch othcr's effort levels.
Tournamcnts which rcwa rd agcnts only as a functio11 of tL.e ranking of thcsc out puts are
t hc objcct of Scction 7.4. In partkul~r, o ptima! toumamcnts a re compared with optimal-
indcpcndcnt mcchanisms. Section 7.5 consiclcr:; thc ~ase whcn agcnts obsen·e each other's
cffort levcls. With thc mcchanisms co11sidered so fa r it is shown that allowh tg >idc-
contracti ng is beneficia! for thc principal as incentiv constraints are we<1 kcrnxl by t hc
agcnts coordin11tion uf efforls an<l tra nsfcrs when our pu t.s are 1l11correlt1tcd. Howcvcr,
whcn outputs a re correlalRd comp t itiou is bct tcr (rcsp. '"orse) thim cooperation whcn
thc rorrdation of outputs is high (rcsp. low). lndced, for a high corrclation . it is bettcr to
prcvcnt side-rontracting becausc of thc high bcndits of rcla ti\-e pcrfonuancc cvaluation
dcspitc thc higher cost of incentive constraints . F'o r low correla.tion ins tead , it is bettcr o
allow ~id c-cont racüng and bcnefit thereby from 111onitoring of thc agem s. Thc principal
givcs up then relati,·e performance cvaluation.
13 1
1 ~2 Cf!APTEíl 7. M ULTI. Gl=.WT .1 / 0 fJJ~LS \\!!TU MORAL IIAZAIW
Sc-ction 7.G , in a ntodcl of banking for risk neut ra l agcnts with limited liabili ty extends
thc rcsult that sidc contracting (coopcration) is bcttcr f r the principal tlw n indh·id ual
com rnct,. Howc\'cr, it shows thaL when effort s ftre mUluruly ob.<erw1hle by the ageHl s,
thc fint-be:,t can be ad1ievcd u11dcr co mpcütiou by didting thc effort lm·els wit b \ 11<·
mechanbrns. Furthcrmorc whcn sidc-contraCLing is allow l or u11avoid able it is >hown
that me;sagc gA mcs are supcrAuou• a nd t h o ptirual collu.sion-proof mecha ni sm is a s im ple
group lending contract such a.q those considere<! abovc.
Section 7.7 roru;idc rs thc case whcrc agents C'&n h lp each other. Fina lly, Scction 7.8
compares, wlwn a ents observe eacb olher's effor t . the opti ma! centrn lired mecha nism
with optima! clelcgation to an agent.
7. 1 Opt ima! Second-Best C ontracts with M ultiple Agents
To foc us 0 11 t ite :;implcst modcl, wc as.s ume that t h re a re only wo agcnts (1 = l , 2) in
the orga 11izA l io11 . Ench agent,"s effort e 1 iti c ithc r c0 =O or t.. i = l with thc co rrc..'5pou<ling
di•utilitics >"(0) =O and lb( ! )= .;1. The out pu t of agcnt A, is dcnotcd by q, for í = 1, 2.
lt can t a kc two poS.>ible n1lucs 'l. and if. Thcrc are thus four po: iblc output ·•l.'Ctors
Q, = (</,</) . CJ, = (17- 2), Ch= (~¡A) and q, "'(2.iz.). Thc rctu rn to t hc principal is S(Q,)
for j = l. . . .. 4. A · lLfütl!, a gcnt i has a utility fun ction U, =
v(l,) - ~'(e ,) wherc l ; is
thc transfcr h rccci\'cs fron 1 the principal HJKI .:·(e,) t hc disutil ity of cxcrting an effo rt e,.
u(· ) is inc-re11sing and strictly conca\'C (u' > O. u" < O) wi th tite uorma liza t ion u(O) = O
a nd wc denote by li (·) its inversc function (h' >O,/¡"> O).
Thc stochasti c nature of joi m -produc t ion mu.st now takc into account that both agcut
exe rt d for ts. \Ve dc uotc by ,..,(e 1 . e2 ) thc positive p ro babili ty tha t Q, is rcalizcd givcn an
cffort pnir h , ~2) excrtcd by bcnh agc uts.
In ful! gcncrality an inceuti ccritruct mu.:;t now stipulatc a \'cctor of tran:ifor> { l,1 } 1 <, < 2
l~j~4
for both agents depeudiug on thc outcomc of bot h productio11s. 1
Let us for thc momellt focus on thc case wherc the pri nci pal wa nts to induce a high
cffort from cadt agcnt. In tb.is non-coopcrati vc multiagcnt c11vi ro11mcnt , wc adopt thc
conc pt of Nash equilib 1~um to de¡c-ribc t he agcut.:s· play of thc gamc which is ind ueed by
t hc contra.et . Each agcnt chooscs t lm< his opti ma! cffor L as a bcst-rcsponse 10 thc cffnrt
choscn by the othcr.
1\11,.$;s.,gc gtul\t":; a.re tL5Cless sincc ag~ts do nol observe f',~Úl othcr's effort lm.'CI.
7.1 . 0 1,Tl .IIAL SECOND-IJE: T COXTHA CTS ll'ITll .\I ULTWLC A CE \ 'TS 133 13~ CIIAPTIW 7. :1 /UL.Tl:\CENT .\ fODEL \\f/Tl/ .\10 11.i\/, llA ZA/10

This lcads to the follo,.~ng moral hazard i11ccntive c:o1J.Straint for ageut A1 : Thc optimality co11ditions witli rcspccl to 'J (j = 1, ... , 4) can be writtcn rcspoctivcly
as:
4 '
L ,,.,(l, l)u(t 1,) - ~' 2 L n (0. l)u(t
1 1,) . (Al ) -;r,( l, 1) ( )) ( )- - { }
u'(t;'ª) +A tr,(l, 1) -11',(0, l -+ l"'J l , 1 - OVJ e l , . .. .4 , (A5)
i -1 J 1
whcr t hc indices "SH" stands for second-bcst.
A similar incentive oonstraint can be \\Titten for 11 2 •
Surnming those conditions o,·cr j yiclds:
Thc eontract must al:lO induce participation. For A" it m1n ·atisfy the following
4
partidpation constraint:
1

L rr;( l , l)u(l1 1) - 1/1 2 O. ( A2)

, -
1 - E "1(-
- l ,-
l ) - F. ( -1- )
u'(IJ) - · u'(i'.,l '
(A6)

J-- 1
wherc E(·) d enotes the cxpoctation opcrator with rcspocL to thc 18'" of Q, induced b · a
As usual. it is useful to introduce ex poo;t utilitics as thc optimization variables. Do- high efforl pair.
noting by u 11 = u(t 11 ) those e>: pos!. utiliücs, w~ can rcwritc (Al) and (A2) as: From (A6), we deduce that I' > O and thus the 11gcnt's particip<1Lion constra int is
' 4
bindmg jusl •s in thc ~ase of a single agcnt.2
L rr,(l. l)u, 1 - V' 2 L n,(O. 1)11 1 1, (A3)
~ fu lti plying (A.5) by u(!;<u) - ,, ancl su nnning ovcr J yiclcls
•-1

a nd
'
) ' '1',( t, 1)111, - ,¡, 2 o. (A4)
A (I)r
,_ ,
r,( 1. 1) - rr, (O, l ))(u(t, u ) - ~'))
1....:.I
(A 7)
Sincc the stocha.; k production function is y1umctric, the optirnal contrnrt is sym-
rnctric. \Ve will focus on that case to simplify notatioris and tlius omit thc ·ubscript t in
wh re ¡r has bccn cxprcsscd fro1n (A6).
th descrip ion of thc optima! contract. Syn1rnctry imposcs that r.,(e,,e2 ) = r.1 (e 2 , c 1) for
j = 1, ... ,4 and "2(e1.e2) = n'3(e2,e1). Csing t h slackncss c·ondition associatcd to (A3), the left-hand side of (A7) ca11 be
simplified to give
Lct us el note by C 58 (1,
1) thc pcr-agent sccond-bcst oost of implcmenting a pair of
high effor . By definition, this second-best cosl is: AtJ = cov (u(iJ8), _;,_B
u'(tj )
), (A )

(P): whcr ¡ss denotes the random niriablc t aking \'alue t'{ 8 in statc J .

Sincc t(i-' 8 )
and u'(t88 )
are ucgati\•cly corr l Le<!, ,\ is positivc and can only be
subj<-'Ct to (A3) and ( A~ ). equal to zcro whcn - is a constant but this would viola te tbe inccnti\•e constrai11t (Al) . a
contradittion. l lcncc, A > O and thc incc11livc constraint {A 1) is also binding.
T hc wo lin ar CO!l.Slraints abovc define aoonstraincd set which is con,·cx and olwiously
Prograrn (P) drL rminc:s th co.<1 of implcm~nti11g cffort by cach agcnt. "imilarly wc
has a non-cmpty interior. Thc principal's objoct ivc function bcing strictly conciwc, thcre
could determine the cost oí imµlcmcnting e 1 = l , c 2 = O or c1 = O. r 2 = 1 to find whi<:h
is a unique solution to tbe problem abm'C.
IPvels of effort are second-b(-st optima!.
Let us denote by A (rcsp. ¡<) thc multiplier of (. 3) (r~-p. (A4)). Thc Lagnngcan of
R e111ark: Even if tlw principal prcfers o i111plcmenl thc comrnct \\'Íth tlw high cfforl
P C<.in be writtcn as:
lcvcl by both 11gcms. it may happcn that for the contract offercd by thc principal, thcrc
are othcr ·a~h cquilibria and agcntti prcfcr a ·a-h cquilibrium whcrc t hey rcach higher
1 ·,,, LM (2002. Chapl<T ·IJ.
7.2. 1 CO.\IPBTITIO.V USEFUL? 135 136 Cll APTfR 7. .\I ULTIA GC:NT MOVLL S' IV/TH MORAL flAZARD

rnllusivc payoff ·. By cxtcndíng subgamc p~rfcct implcmcma ion (as dcscribcd in LM lt is ea -y to check that 1-SB and fSFl are thc optima] payrucnt · that t hc prindpal
(2002, Chaptcr 6)) to perfii<:t 13ayesian implemcntation, la ( 19 ) shows how to construct would havc offcrcd had cach agcnt bcing a.lonc. T lie mu lt il ~t eral contrae! is in fact
extensivo form ga mes such that thc only pcrfcct Baycsian cquilibrium implcmcnts thc obtaincd as a pair of bilateral contracts betwecn the principal and cach agcnt scparatcly.
J\ash cqu ilibrium dcsircd by t hc principal. • '. loreovcr, (Al I) and ( l.2} show that thc compcnsation re<'CiWx:l l>y .4 1 does not depend
un thc performance of .-\ 1 • Relativo com pcn&'\tíon s h mes are o[ no u · \l'hcn thc agcnts '
output • are not correla i.ed.
7.2 Is C ompetitio n U seful ?
).forc gen ra lly. lct supposc that the joiDL distribution of (qi, Q:,} satisfies th following
propcrty :
So fa r, t hc analysis of the second-best optimal contract has takcn cach agcnt in isolation.
(Al3}
Thc m1t ur of the r ults obtaincd me vcry similar o thosc wc gct with a iuglc agem
(LM (2002, Chaptcr 4)): the optinrn l oontrnct is no longer a flat wag.• as nnder oomplete
C ndition (Al3) encompasscs the case of indcpcndent random prod uctions but ha:; a
iuformatiou n11d e<1d1 (ti:;trnt nmst Lt•ar :->OHltJ ri~k to CXl!rt an cttort. Th~
is t h · ~'1.aud a rd
grcatcr scopc.
trnd('.off hctwccn ri:;::k and insurflnre.
A rrai 11 we CHn use (A5) to ha,-c a more
1 ~ orn pac t. xprcssion of A 1, \vag
In thi cction, we wa nt to get more specific results rcla t c<l to thc rnutliagcnt naturc of
the organization. We a.sk undcr wbid• conditi011", thc principal u= co1upetition betw c11 l 1 (Pr (ql l. l ) - Pr(qjO , 1) )
thc agcnts to his advantagc. u'(ty 8 ) = u'(t!'8 ) = ,\ Pr(Qli, 1) ~ µ.
(Al4.)

As a benchmark , let us suppo>c tbat thc agcms· o utputs are indcp ·ndeutly d istribu tcd and
_ l_ = _ I_ = -,\ (Pr(r/ll, l } - Pr(qlO. l)) + 11 (.'\ 15)
so that: u'(t~ 8 ) .,•(t¡8) Pr(~ll , l) ·

\\fln1 (i\ 13) holds .'1 1 's compcnsat ion again docs not dcpcnd on wbcthcr :1~ ' Ul"COOds
To simplify not ations, we denote rr, = Pr(q1 = qJe,) for 1 ,., O, 1 imd j = O, 1 so tha t, or uot.. T lw Q:, produccd by A2 is unínformativc o n 1!11> •ffort e 1 cxcrtcd by 11.
0 11 t p11 t
fo r íns lance, "i( l , ! ) = rrr and n1(LO) = ir1( l - ,,., ). In o thcr wonls q1 is
t.hcn a s •.1fficie11t statistics for th<' pair (i¡ 1.q2 ) with rc:.pe<:t to e 1 . lt
Sim plifying by"' into (AS) tlic wages t, H obtainl"<l by A 1 when both age11ts s\lí'<'OCd i · thcn usclcss for thc principal to rondition A 1 ·s pa Tncnt on the rcalization of ifa. Doing
a nd produce a high output is solution to: so w 111<! i nc re;i,~ the rnndo111nes · o[ A 1 ·s payrncnt without any in cutivc bcncfi ·incc
t hc risk-aversc agc nt obviously dislikcs this randomncss. lt is only iI A2 's performance i:;
.\.ó.rr + i'"' = O, ( 9) inforrnati\'c about / \ 1's d fort that linki ug cornpc11.>atioi · is u:;cful.

Wc can statc thesc results as a proposition.

wher' ~ " = ir 1 - 7ro > O.
irnilarly, simplifying by 1 - "" i11to (A5} tlic wagc tf 8
that ;1 1 gets when he ·ucceeds
Propo ·it ion 7.1 : !j the produclion o/ª" a9e11 is a sufficíe11t staJt,i&c ¡, r thc vector
a 11d A2 foils i:; gi\'CU by:
-¡¡-, o/ outputs unV1 rc>pect to h!.s own effmi leve/, h1s w111pcnoalior¡ al lhc o¡Jtimal cnn tmcl '"
u'(lf') + .\!l.r. + 11" 1 =O. (AlO) independe11 t o/ the other agml · performance.

Compa ring (A9} And (AlO), wc immediately obt ain thAt

Prop il ion 7 .1 o!Tcrs a bcnchmark lo asscss undcr which condi t ions thc prindpa l
(A l i ) finds beneficia! to link the cornpensatio11S o f both agent.s. W hcn the agcnts work on two
t · hnologics which are indcpendcnt, thcrc is no gain in tryi ng t.o crc<1tc co111pctitio11 . Thb
Similarly, we also ol>tain from (A5) is thc c~c whcn thc rctmns </, are indcpcndcmly distribute<l as ""' ht1''0 s hown abO\'C.
On thc contrary, corrclation bctwcc11 thc shocks affecting the age 111> lllH>' iequirc linking
(. 12) thci r compcnsations.
72. IS CO.~Jl't:T!TiON USEPUL? 137 138 Cll.4 /'TBR 7. .\JULT IA GE:\'T .\JODELS WIT Jf .\ JORA L J/A.ZAHV

Exa mple l. : Supposc that outputs e re pcrfcctly corrclatc.od íf both agcnts exert a posilivc 7.3 Tourname nts
effort, i.e.. r.2(1, l} = ir3(1, l } =O, but supposc also that thcrc is a strictl.v positivc prol>-
ability thAt outp\lts Me dilfcrent if one ar,cnl dcviates a11d exerts no efforl. In tbis case, A >pccific class of incentive schemes has attracted nmch attcntion Íll ruultiagent contcxts:
by using tbc punishments t 2 = t 3 = - , the principal can cnsure incentive compatibility tournaments. Tournl'l111ents differ fro1n other contracts because tliPy use only the rnnkiug
at no cost if u(-} is not boundcd bclow.3 In othcr words, thc dcviation by auy agent can o( thc difft>rcut agents· P•'rformauccs, not thcir a bsolutc v-JluC'S . As suelo their informa-
be detected, at lcast with sorne probtlbility, a nd thus can be ostlessly prcvcnted if t he t ional rcquircmcnt is lhuitcd comparcd with the 111orc general schenK.,; discussed in Section
maximaJ pm1ishrne nt i ··suffi.cicntly he~wy" .4 7.2. Thcy '" "Y be fouud 8> quite attrnct in~ in this rcspe<:t.
Ex:rn1ple 2: Another c.·amplc will illustratc the links bctwt'Cn the compensation of both Consider a principal two agcnts problcnr with the producü on technologics
agents whcn thcrc is some correl>ttion bctween their outputs. Lct us supposc that
q, =t', + Eo+e. for < = l , 2.
" 1(e1,e2) O+ ( l - ll)ir{e¡}7r(e2} .
ir2(c1, <>2) (l - il):r(ei) (l - ir(c2)), e, is /\,"s effort le'"cl which is suppos d to b.. a continu01L' variable in t his seüion. .: 0 ,
<,, 2 are rnndom ' hocb which e re indcpcndcntly distributcd ";th icro mean. co is a
ir,(ei. c 2 } (l - 0)(1 - 7r(c 1))ir(c2 ),
co1urnon ·hock whilc ~ .. i = 1, 2, is ti, 's idiosyncrntic shock.
;r4(e1, e,) ( l -8)(1 - -rr(1' 1)){l - ir(c2)).
A,"s utility function · · U, = u(I,) - ~:(e,) as befare a nd th rL5k neutral principal's
whcre O < O < 1. The paramctcr 8 mcasu rc:· the corrclation uetwccn thc pcrformancc:,; of utility funclion is V = q, + '12 -11 - t2 .
both agcnts. As fJ incrcases, thc agcnts' outputs are t lius more posith·cly corrcle ted. A wurnamcnt consbts in spccifying a pair of rcwards /1 1 a nd /i2 with U 1 > llz and
Turning to (A5}, wc immediat.cl' obtain: 1, "' R, if and only if •J, > q, . R, is t he pri>'.e of thc most prod11ctÍ\"C agcnt.

,\ ( l - il)ll:r "1
Lct P = Pr{q 1 - rn > O} be the probabilíty that A 1 wins the tournu111cnt. \Ve c~ 11
u'(tfl) 0+(1-ll}ir? + ¡>. rewritc this probability as:
l
u'(t~R) '"'"
, \ - + ¡s.
" 1
P = Pr{o-2 - <1 < 1- c2} = C{e1 - e2).

wlu'rc G( ·} is the curuufoti,·e d istribution funct.io11 of ( = •2 - .c 1. and g( ·) is its associlltC<l

Froru which we ded uc.-c that tf 8 < tfR. Using again (A5), \W would a lso obtain dcnsity fmwtiou which is upposc<l everywhcrc positive.
t~R = 1 ¡u In othcr words, A 1 gcts a highcr rcward whcn A2 fails ths11 othcrwisc. The
intuition is strnightforward, when Q 1 = (ij, ij} rca lizes, the prindpal finds it not ver~'
informa i'·c on whethcr 1 has cxert ~<.l a high cffort or not . Aftcr a ll, thb ota t. coukl
a risc becausc of the high corrcla tion bct.woou thc agents' outputs as soon as A 1 has al:so
exertcd a high cffor l. lnstead Q 2 = (q,q) is more informative 0 11 thc A 1 " cffort . C h-en A symmet ríc cxprc:ssion outaincd by pemrnting indiet.'S can be similarly ob aincd for
he pooi ivc correlation uetwccn thc outputs, thL~ is wbcn A 2 faib t ha t a high output by A 2 • W c will assurnc that /\.'s objecth·c is qna~i-concavc in e..
A 1 is a more informative signa) on his elfon lc"cl.
Ar a symmctric i\'ash cquilibrium in cffort lc,·cls, c 1 = <>2 =e, dwractc rir.t;(I by fir·t-
Thc logíc of the argumcnt hcrc is ,·cry similar to that prcscnted in LM (2002, Chap- order e<mditions. wc hH'·c:
wr 4). T he linkage of the oom¡>em;atíons of uoth agcms is a nothcr COBSt'q ucncc of tbe
(u(/?,) - u(/l2))9 (0) - ~/(e)= O. {Al6)
·•foj omiatwe11ess Pn nciple ".

'Note that we use h('re the fact that the ~upport of the productton le-\'t'I shihs ._,·ith the Je,"t'ls of cITvrt. ~(oving uack\rnrds, thc principal's O(J iruizat;ion progwm b com ,
\\'e know from L l (2002, C'ha.pte1 .&) tlmt il l:, thcn C{tsy for a prindp<Ll to obtain thc first IJt_"=:it with om.:
agt·11l.
"S.-c f\.lwkJ)CIJC"C ( l . Ptopoi:,Jtiou 5) for a ul n: general d1.:finitio11 of ··suffincnUy l1ea1..71".
(P}: max 2e - R 1 - H2
(R 1.RJ ,d
7.3. TO URNA .\IESTS 139 140 CllAl'Tt:R 7. .\l LTJA GENT MODEL \ \ 'ITll .\/ORA i. llA ZAllV

subject t o (AI G) and
G(0)11(R1) + (l - G(O))u(R1 )
which is the participation constraint of cither agcnt.
Dcnoting " ' = u(R 1), u 2 = u(/?2 ) and h(·) thc invcrsc function of u(·), wc con rcw ri t
this progrn111 as:
(P) : max 2e - l1(u 1) - l1( u2)
(R 1 R'f,c)
subjC<:t to
(111 - 112)y(O) - e//(<·)= O
G(O)u 1 + (l - G'(O))u2 - 1,.1(e)
Lct denote CTÓ= Var ,-0. u 2 = Var <1 = \lar <1 th respective \"Rrianccs of the variOU!>
- t,:·(e) ~ Q, ( A1 7) shocks . \Ve s im rncdiately t hat the cxpcctcd pa ·off of cach agcnt is indep~ nden of
CT~ a ud similarly for thc principal bccausc of his risk-neut raliLy. ln fact. t hc corumon
componcnt -0 of thc noi ·e wh k.h liit!) t.:<:u..:h tlg:~nt dÍfe<. ts tltcrn iu th · ~u 1c Wt-\}' <Ut<l dot>:>
llO! in q>act m1 t hc· ranking of t hcir prrformanccs "'hid1 is onlv d<'lr rr cc inrtl by th<'ir cffort:s
and thc idi0:>·yncbratic dioiccs e: 1 ancl e:1 .
Consider instcacl (m a ffinc in<lcpcndcnt schcmc wbcrc A, obt ains a rcwft rd r q, + 1. The
pi<'<'c-rn t r is a positivc but. 1 .. t han onc and I a fixcd paynw nt. Thi.• i\ffinc scheme
mak · ach agcnt ·, l'Otnpensation independen t of that o t hc othcr.
(Al ')
Faeing thi. schem , A, cho°"'-'S thcn a n cffort which solvcs
~ Q (A19)

Onc can c&ily check that thc two linea r coru;train · (Al ) a nd (At 9) ckfi 11c a conl'cx
constrained set "'hich has a no11-c111pty interior.
T his prol>lcm is ro1wm·c in e, and thus the optima! effort is given by thc first-order
0 1.m oting by ,\ ancl µ thc respective multiplicrs of (Al ) and (A 19), 1 lic firsl-ord r conditíon
ro11ditions for the prindplll's probl ·m can l>e written as: r E (u'(r(e +<o+ <H /) ) = •/(e), (A26)
(·o.e)
,\d'( ·) (A20 ) wlt re wc c) n1i1, the subscri pt. i bcca u::;C' of .s mmct..ry. 1

,\g(O) + µG(O) (. 2 1) /\,' · particip;:ltion constraint ca n a)so be wri ttcn as:

- ,\g(O) + µ(l - G(O)). ( 22)
E (u(r(c
(!"o,c)
+ .-0 + ,-) + !)) - ü(e) ~O. (A27)
l lcncc, we imme<liatcly get:
\ \'ith indepcndcnt :>ebcmcs, the pri 11cipaL· bilat crnl rontracL with cach agcnt soh·cs:
(1 - G(O))li'(t1t) - G(O)h'(u2)
/< = li(u1) + l/ (u2) >O and ,\ = g(O) nw x (l-r)e- / .
(r,ce.,/}

From (A20), wc ohtain ,\ > O. Thcrefor , both (. IS) and (A19) a re b inding so 1.haL subjcx·t to (A26) and ( A2i) .
the o ptima! le vPb of ex post utiliti0 · whethcr one :mccccds or no t are gh•en by:
A ~s u mi np, conca\•ity of thc principal's o bjcctive function in " and denotíng rcspecti vely
º"
·r¡.!(r·ºu) l --
+- G(O)
- e/: ' (r SlJ ). (A23) by,\ ru1d I' t he mult iplicrs of (A26 ) a nd (A27), thc first-ordcr condit.o ns wit h rcspcct to
g(O)
and f are:
SB G(O) • SB
v(e· ) - - ~·(e ). (. 24 )
g(O) l - r + ..\(r2 E(1t") - t,'.•" (e)) O, (A28)

:\s<nming ronravit~· of the prindpal'.· ohjf'f'rh·e fur l<'lion, the optimnl effort solves: - 1 + ..\rE(u") + ¡1 E(1,') O. (. 29)

From (A2 ) a mi thc l'Onc;:cvity of tire agcnt's objectivc func tio n, we g t ,\ > O and
11E(u') = 1 - .\ r(u") >O so that !Joth rons tra ints are binding.

Th1s <·ffoct leve! shoukl of rnursr hP N>lllparr<I with thc first-bc:,t lcvcl eFR which i.s Lec \/(-) denotes the prin ipal' cxpc"<'Lcd ,'Clfarc as a function of CFÓ, \\'C havc:
»uch th(tt h'(v(cFB)) ~i(cF 8 ) = l. Note that li'(uf 8 ) + h'(u~R) > /1'(1,.1(e58 )) wh n /¡' is
()V ,\. ()F,(u') fJF.(11) (A30)
rom'<'x. Thcrcforr u;iug (A25), h'(v(e 88 ))1-/(fSH) < l and thus cSB < cF'B. ou5 = r au~ + /l au5
7.3. TOURNJ\ME.\"T. 141
whi<:h. sinre .A >O and µ >O. will be in gencral 11 garive.
Wc can cxpcct that, for high .,3 at lcast, thc tournamcnt which provides a utility leYcl
independPut of tite v11.ria11Cf' of 1be comrnon shock dominates affine independent schemes.
lndeed. this me<:hanism <loes no insure the agent for 1h conunon 8hock wbilc he drawlx1ck
of the tournamcnt is to force an agc11L to bear ri~k rclatcd to thc idiosyncratic shock of 1he
other agent. This comparison betwccn both :;.:·heme i. 11ot iJume<.füitely obdous bocausc.
as risk incrcascs. t hc agent has more incentives to exert ~ffort nn<let the line11.r rew,.rd
schemc. llowevcr, a greatcr sharc of output mm;t also be givcn to him to induce him to
ru;cept the contract. This is a drawback of this lincm S<'hemc.
Lct m; supp<kiC tha u(x) = ;( 1 - exp( - px)) whcrc p is thc con ant deg roo of risk-
avcrsion aud lct us suppose that (t o,<: 1,<:2) are nmrnally distribntcd. Thcn, wc havc:
E (u) = ~/) [1 - E (cxp(-p(r(e + Eo.t') + /)))]
(<o,<) <co.<)
~ (1 -exp(-p(re+ /))cxp (".~\"~ +a 2 ) ) ) .
l;sing this cxpression , and (A30), \\'e r.a.i a frnally conaputc ~ = -l < O.
Proposition 7.2 : The prmcipa/'s utility is strictly decrrosing u"th lhc varianc.c of tJ1 e
commo11 hock oJ. T /1e11:
• lf f or aó = O tlie opllmal tourno me1Lt dominales t/i e optima/. ajfin' schem , il dum -
iriates for any aJ.
• OtJ. enm e. lh er'f' cxisls o0 s11ch tliat the uptimal toumament dom.males if ami only
if aó >u;/. 1.e., the vanance of the commo11 shock• /.o.rgc enough.
By definition, tournamcnts are rclati,·c performance schcmcs and are thus always
dominated by 1.lte optima! nonlincttr s uth mcchanisrn t bat would makc t hc compcnsation of
any agcnt dcpcnd cxplicitly noL only on his own performance but also on that of t hc othcr.
Of courS(', thc fact that this optima[ :;.:·heme dominates stnclly thc optinaal tournarneHt is
vbvtous w lt~n Lhc variancc o[ lh<' common shock is ··ufficicntly su1111l. lnd ·ed, in Lha \ c...,,e,
we alreadv know from Section 7.2, tlwt thc optima! si:hcmc consi>"ts of indcpcndent wages
where thc rc·wa rd of an agent depcnds only on his own performance:>. T he performance
of th<> >econd ag••ttt <loes not bring any additirnrnl in formalion on tlw c•ffort of th<' firn t
onc and usiug il to compt>11S8te thc firnt onc would only add somc noi.,;c in compensation
whkh is r0>tly bccauoc of risk-avcrsion.
142 CIV\P TEll 7. .HULT IAGE:\'T MODELS \\'ITJI .\fORAL lli\ZARD
l!enee, mcaningful comparisons can be made only after having imposed rest rictioru·
on genera l mechani"n"' which U;;(' thc perfonnanccs of botb agents. T hb is what wc h""c
done in Proposition 7.3 follo"·ing the work of Lazror and 1iosen {1981).
~ In " sli¡;htl diffcrrnt frame work whc-rc agrnts ohscrw 1h<' mmmon shocb hrforc
decidin,e: t h<'ir pffort l<'v<'l ,5 G reen and Stockey (1983) show that the opt ima! nonlinear
indcpcndcnt contract dominatcs thc optima! tournamcnt whcn thcrc is no common error.
On he othcr ha.nd , whcn t bc dislribution of t hc common shock is suf!icicntly diffusc, thc
ranking is oppositc. The:;c authors also show tha t , when the numbcr of agcnt.~ goc:; its
infinity, thc optima! tom narncut is asymptot ically dlicicnt beca use t hc rank ordc1 of a n
agent's observed outpu r, is n v ry nccu ra timator of his output nct of he con111 1on
shock. T his rcsult is ncvcrthelcss of a limitcd intercst as most rclevant cases for organi·
7.Ation thco r.v eutnil only snmll mnn bc rs. A" importa nt wcak11css of this <1ppro .. ch is tba.t
thc optimal mcchanism should nse tbc fact thaL t he common shock e is observab le by
both ag<:mts. lt w uld indccd be casy to C<.>~ tk,;;;ly clicit this cornruonly known piccc of
information with a revelotion sch me il la M o~kiu ( 1999). 6 T hcn , it would be c11 ough to
npp~nd to th is mC<'hanisrn sorne indcpcndcnt no nlincar schcme to ind ncc cflort ~x11.rt l y FL<
if thc common <hock was aL50 known hy th principal.
Tlti:; d i~e= ion shows tlaat thc 1:omparison bctwccn to urnaments and piccc-rate con-
t ract • L~ rnther ·11btl · since it itwolves th insurancc aad inc-cnÜYe propcrtic" of bot h
mcchanisms. Within the complete contract approach, 1ou rn>1mcnLs are el 'arly ubo r Li·
na al n 1ed1a11isrns as thc \\'itSte lo · uf infornaation about pcrforruanccs. Variou:; argumcnts
lHl\'c bc'Cn proposcd to ncvcrthcless explain their common use. Somc havc argued tha.t
ob;;en-ing rnu king of pcrforrnanccs is casicr than obscrving performance lcvcls themsck cs,
a rath r <lo ubtful 11rgumcnt . The optima! tourna 111ent has <1 Go bc'<'n found ·'robust" in
th scnsc tha L it indcpcndent of t he distribution of the common shork (1'!alcomwn
(19 6)). Furthermorc, sin ce thc paymcnt rnadc by thc principal is indepcndent of thc
pcrformanccs (since there is always a wiuuer and a l<x5cr) tournamcnts are robust to
1
th non-verifiahility of t h performance;, which clinaitwtes a possiblc umnipulation of tbc
results by thc principal or by somc monitors. l lowevcr , to urnarnents can be s ubje<::t to
collusion bctwccn agcnts while indcpcndcnt contracts are not.
))espite the:;c argurne11l.s whida ccrtainly ali contain a grain of truth, tournamcnts
ha"· not becn com·inci ngly s hown to be optima) undcr collusion-proofness , ,·erifiability or
cnforccability constraint.~. Attcntion has shifted towa rds more modcb analyzing general
rclati,·c performance c •·aluation.s. Scc Che and Yoo (2001) for a rocent ventnre of this
litera tu re. •
e. rt is alw tl1t.• ír.;un~woik uí N1;tleLuff ~ r1 J S~ iglit~ { 1 9~3).
{)&.'<" La.flonl f\11 il ~forliu1o r l. (2002, Chaptcr 6) .

Chapter 8
Moral Hazard in Teams and the
Free-Rider Problem
Appa.rently at least sincc llobbcs, cconomist.s hR\'e viewed firms as eharucterizcd by somc
form o f ·cale or soopc ·onomie8, i.e., b.r incrcasing retu rns from joint production. This
eflki ·ncy gai n from merging mn\t iple t asb and acti,·itics iato thc samc firm comes ha nd
by ha nd with the dirriculty in measuring and decomposing the individ ua\ contrihutions
oí cadi "gcnL Lo tl1c fu111 ·s p1ofit. Tlti.· diflic ulty is al thc origin of au i11ccutiv<! problclll
of" parn mount importancc. As thc individ ual contrí bution of each worker to thc joi11t
output of thc firm cannot be mcasured prcciscly, cnch workcr has strong incentives to
shirk an l o rely on tbc cornplcmcntary cfforts of his t~amrna r e.;; . Wl 11·n s hirki ng, <'ach
individ ual agent gains by not payi ng tite monctary cost of his cffort whcrcas the cost of
such dcviation is sprcad ovcr al\ mcrnbcrs of the firm.
T his is the esseucc of he "froo-ridcr" problcm which is thc forns of this chapte r. 11 is
foir to say thal undcrstanding moral hAzard in tea111 prod union is crucia l to undcrsta nd
thc organizational forni.> that capita li>.--t firms may t akc.
To Sf' tl 1e stag and alreacly high ligl" tha t incentive problcm , wc start in Section
'. l by reYisit ing thc standard principal-iuultiagcut hicrarchical modcl airead y discussecl
in l haptcr 7. llowcvcr, wc spccializc thc production function so thll t ouly an a ggrcgatc
p rfonnnnce rdated to thc agents' efforts is oh:><'rv• l.Jle a <l<l can be use<l for conlracti ng.
Wcre cach i11di,·i<.lual agcut risk-ncutral, thc principal cou ld easily make each of the111
r°"irlual dainrnHt for t,h(> firm 's pt ofil tn aliµ,n hcir pri ,,¡ im'l'ntivcs to !'Xc>t t l'ffott and
the optima\ onc from thc firm ·s vicwpoint (Section 8.1.1) . .'uch µoli cy may not oc fea "ib\c
wh n the principa l has a lcss active role and bcha\'CS only as a br()(-kcr who redistributc:>
th firm ·s profit amonp, tcammates. Tbis lcads to thc analysis of workers tcam~ made in
th rc:;t of thc chaptcr.
~l d king eacl1 agent re:;idual da imant may also be problcmatie whe n worke rs a re r" k-
163
I G4CII APTER 8. .\10/VtL líf\ZARD /.\! TEJ\ HS AND T NE FREE-H./UJ::H 1'110/JJ. IC:M
a,·crsc and ha••c a dcman 1 for insu rancc. \\'ith risk-ave rsion , wc sho' · t hat a rnther w ·1k
a.ssump ion on th tcchnology, namcly tha t an agcnt 's cffort becomcs a t t hc mflrgi n less
n1luabl<, "-' 0Lhn1; have »lready ~xe r l e<l "'' effort , is enough to makc the individual incen-
th-c constraint more costly as more agcnts gct invoh·ed in product io to (Scctio n 8.1.2). To
avoid thosc sorong ineenci,·cs to frnc-ridc, thc principal rnay want to facilí tatc coll usive
llcha,·ior w that thc c.xternalit)' that an agcnt ' ·rls 011 the other is bctl.Cr intcmal-
ioe<l. Altcrnativcly, thc principal may also want t o improve supcrvision to bet.tcr d tcct
deviations (Sectioto .1.3) .
Thc corc of thc lit ·raturc on the froo-riding prol.Jlem in moral ha;:a rd c t1vironments
ha:, a11«lvzc<l tbc rnsc of tcams whcrc workei.· sharc the proC<""-i of thcir c lfrn t~ . In
thc business world , such partnership are not u nco111mon partic uforly in scf\·icco (la" crs.
docto rs, consultants .... ). · shown by llolmstrom (1982) in as minal paper, the neccssity
to balance t hc budgct n;iscs ne"· i11cc11tivc prob\cms c,·cn " ·hcn agcnts are risk-ncut ra l
and product ion is dcterministic. Aftcr having derived a s tri nge ut condition on '" Urplus for
implcrncn1in¡; a :\a.s b cqui li brium in a modcl 'vith s tochastic production a nd binary efforts
(Section 8.:!.1 ). \\'e a nalyze <lilferfütiabl ... sdiemes (Sediou 8.2.2) stressi ug th<> incJ!iciency
of tcams. Optim3l second-bcst tcam contrncts are thcn dc ri,·cd when t hc agenls are
risk-avcrsc (Scction '.3. 1).
This inef!k iency of te"ms lcd Alchian and Dernsetz (1972) to argue that the mRin role
of a manager is r.o ~upt'rYise c·fforr l<'v<Jls in or<lcr to al le,; alc shirking. Ho\mstrom (1982)
instcad poi uw<l out th, t a n out ·idcr may be nccdcd to break he budget a n<l ra isc thereby
efficiency. \Ve th u> a.,k wlael he r an outside principal can improYe on t he t eam ou tco me
and midcr which conditions ( cction .3.2) .
Final\y, i11 mueh principal-ugcn rclationships. thc tcam problem ta kes a p" rLic11l 3f
for m: t hc pr incipal a nd t h agcnt a ro 1 oth involved in tlac pro duct ion proccss. Exa mplcs of
t his sort abouud (franchisor-franchiscc . land\ord-tenant , teachcr-s tucl nt , etr.). \Ve •tudy
this second-bcst. problett• in a structurcd ctw ironmcnt and show how simple institutions
and conLrncts m e.y a L least partial ly sol vc the dou blc moral-hawrd i:;:,;uc.
8.1 The Principal-Multiage nt Model with Joint Pro-
duction
Consider thc sa nie general frnmcwork as that in C haptcr 7 bu t lct. us now s uppose tha t
the principal only obscr\'c a.o aggrcgatc performance 'I in {~. q} which rcsults from tbc
join! cfforl.s of t he agcnts in product ion . T hc princ·ipar,, heiwfit S (q) assodate<I o his
aggregate p rformancc etm take Lwo ,·aluco ;l. = S(itl and S = S(t¡) respectivcly. \\"e
deuot<> Ll.S = S - {i. T l1e principal wa nts tite r1geuts lo coopera tc in providi ng effort
1' 1. T I/E P/LJ1\"Cf PA/,-.\IULTI.4.GE.\'T :\IOOl:.'L \\'!TI/ JOJNT PllODUCT/01\ ' 16!:1 IG6CllAPTI::R . .\IOR./\L /IA ZA IW /.V Tb'A.\IS .4 1\D Tf!E FREE-RlDER PHOULt:,\J

dcspitc Lcing unablc to ob:;erve thcir individual contributions to thc production pro ·. . Let ns assum<> l hal it is oplimal to havc both agcnts ex rt an efforl wh ·n f'fforts are
obscn ·able aud vcrifiablc, i.c. , thc following C'onditiOll hold ·:
To ,;m¡>lify somewhat notations, W<' assumc t hat the probabilities that ij and g_ are
re ·pt:<I ively r alized dcpend only on the sum of l he agents' elforl c 1 + r2 \\ here <, bclong:;
0

t::.S > -~-'·- .2 ( A3)

to {O, I} . Wc denote tho:,e ¡.¡robabilitiC'S rcspc<'tivdy by Pr(qll, 1) = ií: Pr(</ll , O) = - 17-11-
Pr(í/10, 1) - 'ir and Pr(q,10. O) = :[, \\'ith thc 111011otonicity constraint ir > :T > z¡:. For
fur her rcfer nces, we al.so denote ~ 1!' = ff - -ir f\tld :;.. ;;;::; if - zr and ~rr = -:r - .E.· ll'c ct111 casily check that, givcn l'(q), it is" ·ash cquilibrium for cach agcnt to ' Xert
This "to<::h8.5tic production pro('(! · · dcarl cxhibits a public good ÍC• ure. Each agcnt , an dfon :i.in«l'
by cxcrting an cffort, makcs an individual contnbution to a joint production which is thc
rr(S - T ) (1 - ;T)(,1-T) - .., ;:: rr(S - T ) + ( ! - rr)(á: - T), (A.4)
only ob:>crvablc on which a contract can be signed.

Lct {f,f} lw the i1wcntive schcmc offcrcd to cach agcnl b · t hc principal. \Vithout loss A11d thu (Al) is satisficd.
of gen rality, w u.se thc symmctry h<·twccn <tº 'llt · to justify thar the · rccci,·c th ·ame Thc fixed up-frout paymcnt T is t hcn used to extra t a li thc cxpcctcd profit madc hy
contract.. 1 cach agcnt:
'['= f..~+ (1 - fr)á:-1/J (A5)
8.1.1 Ri k- eutrality so hat t hc participetion con>traint (A2) holds also an eq1rnlity.

To tiummarizc thc ana)ysis abovc, W(· lwvc:

Lct us firsL ·uppose that agent.5 a re ri ·k-ncutral. AL a l'\rc>h cq uilibrium whcrc both
agcnts cxcrt a high cffort, l he following inc~uth·e constraint ha:. to be sal i,fie<l to prc\'Cllt
Prnposit.ion 8 . l : Jf boVi agcnt• ure risk-11c11tml. the pri11c1pal ca•1 1mplement ti.e first-
individual deviations:
bcsl oulcom a.t 11 0 e:rpectcd cost eten tJwuyh cfforl• ore non-ob·ert•able.
:r1 + (l - 7r)! - 1/•:::: ;,¡ + (1 - rr)L- (A l)
This propo;;ition show · that in he al..scnce of any finan<:ral coru,"train on th risk-
Given thal he expecl• that his reammatc cxerb M effort , each agent prcfers to work
ncutral agcnts. thc principal cun C'Ostl · ·ly delega te the C'Ontrol of tbc ccb110logy to thc
har<l himsclf rathcr than to shirk au<l d1, iau.. unHatcrnlly tow111·ds wro dforl.
age111" ('W t though tbeir effort~ are not obsPn·ahlc. To do so. it Lq enough lo mllke e(1Ch
Thc corrcsponding participation constraint for c;¡ch ngcnt is: agcnt re. idna l dai1na.nt for thc irnpact of hi' 1·ffon choice on thc wholc profit o[ thc finn.

itt + ( I - rr)t - .., :::: o. (A2) This solution is attracttv • bu , cvcn if agcnts are not p rotcctcd by limitcd linbili y,
othcr q uite nutural financia! constnünts may foil to be satisficd. fndecd , the total tra 11sfcrs
Thc principal's problcm is to fi nd a contract •d lich ruaxiniiw,; thc cxpcctcd profit of offerP<l lo hotb ar,~111. may he <lifferl'lll fonn r.lw wbole prnree<l o( thc-ir joint pffor" \Vli~11
thc hicrarchy he forms with the two a"cnts: thc projcct surceeds, wc may ha\'C for instan ·

(P): ma.x ;(S - 2i) + (l - if)(S - 2t) 21º = 2(.~ -T) = 2 [( 1- íf )t::.S + ,µ¡ > .':,
~n - -
>Ubjoct to (A l) and (A2). i.('.. thc total wages giwn to thc agcnt cxcred the total gain for thc hicrarchy of t hc agents'
cffor s. In t hat c "$C. 111akin¡; cnch agcnl residual dairn11nt for thc fümºs rcturn on his 0\\11
\\'h 11 thc risk-neutral agcnts hiwc unlimitt'<I liability. thc principal can casily ob nin clfort is only fcasible \\'hc11 thc principal bchavcs as a ,· urce of fuuds.
thc tir,,1-b' cffort without lcaving thu11 a11 • rcul. lt is cuough o offc1 thc pay111cuts
t"(<i) = S(1/) - T r.o cach agcnt wbcrc T is a fixcd up-front paymcnt. By doing :,o, cach Similarly. whcn thc projcct foils, we may also havc
a¡\ellt is madc residual dairnanl for the impact of l1i.< own effort ou the \\'hole hierard1y's 2r = :.!(~ - T) = 2(-rrt:. S +¡;;)<s...
p rofit.
1 ott> that (A3) ímµli~ ... tsu thal 1l b '~""t'r oµtm1al o it1JU(.'1! no cffoc fro111 IJott1 :;1gt-11t-8 u11<lt<1-
1Tl:us ts without. khs oí genera.lit:-' as lcm~ ,\..., lte p1indpal want.s both l:l&t"Uh> to excrt an dTon. ron1p!t•h· i11fonnat1on
 .1. T U I:: PRJ ,VCJP.'\l,..M LTl .'\C/:J1\"T 11/0Dt:L 11'/T ll JO/NT PRODUGTJO:V 167 J6SCIJA PTl·:n 8. .\ fOIV\ L l IA&A lill I N TEA MS ANO T I JE FREE-RJDEH PRO BLE.\ /

$O thet thc µri ncipal makcs a p05ith·c profit by red b t ributing to both agents k."'lS thflll the Non-Coope rative Bclrnvi o r B tween Agüuts
full proceeds oí tbe produ tion.
Ld u · uow t urn lo t he l'ILW whe rc e lfm ts are 11011-obs<-rvablc and agcuts adopt a l'\ash
As wc will arguc all a long this ch<1 ptcr, tbis is tbis role o[ thc principal as a budget-
beha,'Íor givcn thc contracts they rcccive.
brcaker that distingullihc.,; the ' 'Crtical firm from an hori>.ontal !Rarn. Uy bcing ablc t o
break thc finn·s budgcL, thc principal may be ablc to relax thc conflict bctwce n inccnti,·c \\"hcn both agcnts cxcrt cffort, thc principnl 's prublcm is now:
L'OllS Lraint and budgct balauce that would arise othc rwisc.
(/'"" ) ' maxir(S - _h(ü)) + (l -if)(,l-2 h(.!!))
1~ ... }
He m ark: With thc optima! trnnsfers C(1i) = S(1j) - "/ ', thcrc <loes not cxist any ot hcr
Na:;h equilibrium betwccn the agcnts. In particular, (e 1 = O. e 1 = O) is not t1 l\ ash subj~t to
eq uilibriu m sin~e participation const raints are 110 1 .' a tbfie<l a ny more with this <"ffort p ir .
lndccd , wc ha"c'
(A7)

Jir· + ( 1 - zrlr = ES+ (1 - E)S. - T =.,, - (rr - E).6.s <o. (A )

w]1cre (A7) is an agent·s incentive constraint. ata sym1Hctrk J\ash cquilibrium aud (A :'I )
whcn (A3) hokls.
is his participation connraint.
\\"e lcavc as an cxercice for the reader to check that (.- 1 l , r 2 = O) ís nota Nash
Dy dirtoetly exprcssi ng (P'") in t rms of t hc u·s, wc casily check thc convcxity of tl1e
cquilibrium cither.
• const rained set and the strict concavit oí thc principal's objcetivc.

Thc solutiou to th is [>rob! 11 1 is such t ha t both coustraint (A 7) a nd ( AS) a re binding

8 .1.2 Risk-Ave rsion and we gct 3
(1-rr)if• ru: · 1ft.''
11 11 r.: = 1,/: +- --; !! =~;- - . (A9)
/!.r.
Suppose "º"' Lhat agents are risk-avcrsc. With our usual nota Lion, wc defi ne thc invcr:;c
6.rr

func tion of u(·) as li( ·) = u- 10. Also, wc de note t he payoffa of cach ageHt in e11<:h statc IJcra tJ se thc only observable available to thc principal is a n aggrcgatc perfonm1ncc of
oí naturc rcspecti,· ly by ~ = u(i) and !!. = u(O. Finally, let 6.rr = rr - if be thc incrcmcnt the agent's efforts. t hcy rccei,·c collectii·e punishme nt s and rew¡ird.,:; " " ~xernple oí a Jom l·
in prohability of wcrcss if au agcut chooscs to cxcrt rut cffort. perforrrwru:e cvaluatwn. Uot h agcnLs •tr sim ultAneonsly rcwarded for a good pcrforntllnCC
arnl p11nL5hed for " bRd one.

For Lhc quadratic h(·) func tion "pecificd abov1~, thc ovcrall cost borne by the prin ci pal
Obse rvable Efforts
to irnplemv11t u µair oí high cfforts !ll. a l\" a~ h e<.1uili Uriu111 i::; uow:

\\"hcn cfforts a re observable, thc risk-ncutral principal providcs full insurancc to cach ,. l'fi'(l - it ) )
agcnt and implements a high cffort from cach of thcm al a pcr capita cost li(t•). W hc11
C'" = 2 (irh(ú"C) + (l - ir)h(u''c)) = 2 ( v1 + -~1 + ---2-~)
2 2
.
- 2 2 ~ rr

h(u) = "+ ·~' (dcfincd for" ? -n,

tbc pri ncipal's cx pcctcd profit becornes:
lí the µrinc ipal iuduccs an effort by oiily e ne agcnt. thc implcmcntation co.;t folJ5 toA
\"F'R =ff-
r1'(1 - f.)t,11 2
26.f.2
;uid t he pri 11r ipal prPfrrs incl11cing dfo rt h_v bot h agent s rnthrr t han ;in dfor by only onr '
1
5<-e LM (2002 1 Chaptcr 4 ) in thc case of a ingle 8.g(' nt. Tbc analy~is i~ sirnil.01· hcrc.
of them whcn ''O( course. in this asymmeLric l.t'eatment ar a.gents, agents receh·e d1fTerent 0011 t ra.cts. T'lie agi?nl who
('.'((•Jt~.:: lll) dTort rf'fi"'iVNi A. f!rtt Wrt.gC' r. = !1 = O. The other recei\'C5 a oon ru..ct i-;: = h(ü2) .und l·l = h(.!!"2 )
(t\6) wh<.·re ii2 = t,r + (J - ir)~ tuid .!!'} = v - i.;. 'f his i:, lh(' optirntll ccmtrnc t con esponding to the e.a.se of
t\ ~iu gle ageJLt t>."t'rtiug an clJort with llic w rrl"::>t>Ondiug 1>rob ~ hili • il.""; of ~UtX'C:':S a11cl failure.
8. 1. T EIE p JU,\'Cll'Alr.\ !ULTIAGt;NT .\I ODEL \\'ITll JOli\"T PRODUCTJOS IG9 l 70CJIA PTER . .\/OH.A L l IAZA HD IN TJ.::AM /u\"/J T I!/::. FH n ;..RJDER PROUL BM

Thcrcfor~. thc principal prefcrs to induce >l.ll pffort by earh agent wheu: t hem to get son1 c-o-ins11rn n<' . Thc only scopc fo r collusion in this framework with joint
produ t ion comes from t he possibility r hat agents cou ld coordina e thPir eff rt choiccs .
. ,. ·
2
,-r;i 2 (2;r( 1 -r.) ;r(t-i-))
ó ;; S<::t•+ 2 +2 ~- !'l.ir 2 • (AIO) Sud1 joiut choices, however, requircs thnt cfforts are mutually observable t o detect any
possiblc devitttiuu t-\Way fn>111 thc joiut-mu.ximiz.iub effort pair. \\i bcu cffort::; are instcad

\\lhen for iru;tancc 1f $ 4 a11d ir+ 1L < 2:T, i.c., thc technology cxhibits dccrcasing 11ot m utually obscn·ablc at aU, collusion betwccn thc a.gents would no t a lter the inccn i\'C

n-· t urns to cliorl . the brackeled L<:rm on t ite r.h . ·. of (AlO) is ncccssarily positi,·c and thc
constraints and the solution would b 1mrlrnnged.
•
principal !!,i"'"' up more oflcu cliorts uy uoth a¡;e11t' w h<tll dfo rt,, are ll() n-ol"cn·al>le tha11
whnt wonkl br rffiri<'llt. 11ndrr N>mplct.r informal ion . P e rfe ct Collus ion

lndc<'< l, to inclnr>l nn effort, thc p1·inrip11I m 11 ~ t let <'r\Ch ageut locar srnne risk :tml h "s
upp ~c uow tha t agcnts observe cach othcr's cfforts and co!ludc pcr rcctly as in Scc tion
thus t o pay a rísk-prerniuru t o sa t i:;fy this agcnt's participat ion constraint. A s m re 5
7.:J t hat they eflll pPrfectly coord i11 ate C<WleR>l_,. t beir choices of effort t o maximizc thc
t•gents are involved in t he prod urtion rrocess, aud the tedmology cxhibits dccrcusi11g
sum of t heir exp•xtcd utilitics."
retnrns. t hc impru:t of an agcnt's cffort on t hc incremc11t in the rrohahil ity of ~ncc-..,,_,

bccomcs smallcr . Thi.s makcs m re difficult. to inccntivize a givcn agc nt Lo cxcrt an effort. G iven that cooperative bch,wior l>et\\'CCll agents , thc principal must facc thc following
The diffo1encc Let.wccn what be ge ts in e.et.S e uf l::> llCt.<;:,:; a 1ul wliat he g~1 $ o thf•rwbc mu~t :set. o f c:oafition incent ive cons t raint ·:
be increased. Th r ··r-capita risk-p ren1imn riscs 3 [:;0 and this lcad!i to more stringcnt 2(irii+(l -1r)M- 1) 2 2(Jiu+(l-E_)!;). (A l i )
eonditions far implcrncming t hc first-bcst cfforts.
2(r.u + (1 - ;r)!! - .,,) ;::: 2(nii + (t - f.)g) - .,,. (A l2)

Proposit io n 8.2 : lf both u9cn t - 1<rc r1sk-<wc r< c, lhc pr úi á r•nl fa ces a lradc-off bctwcw T hc first of thcsc inc>lntive cons t rain t.s corr · pouds to a ·global" d cvia t ion whcrc "º"'
rffinc r1 cy flrHi iwm.n11u;r and implc11ien t.~ lt'S.~ oflt>n t1 .\'w .. h (.JfmlíbriTJm w1lh J119h effort.~ both " & nl s may joiutly decide to exert no efforL. T he second one corresponds inst ea<l
than ;¡ efforts wen obseroable. Prcvmtm9 free-nd .n9 becomes costly for thc principal. t o tbc case ,·bcrc only one agent ex.-i-ts 11 11 pffort: n "loc;al" dc viation. :\otc nevcrthclcss
t hat , v u in the case oí :;uch an individ ual d viation, thc cncfits of it a re cvaluated
That conclusion is similar to what we o btainc<l iu Volmne l , Chapter 4, when wc from thc coa lition·s ''iewpoint. This rneans that wc ta kc in to account he impact of thc
analyzed the case of a single agent. Risk-avcrsion introduce;"' trade-off bet wee n i1N 1rnn<'<" d ' ' 'iation uy eit her ageut on t he cxpcctcd utility of thc other agcnt also.
and i11ceu ives a11d creatc-s a11 ag ncy cost írom dclegating production t ask to he agents. \\'e ca n rcwri t c thos ' const rai nts respectively as:
The importanl specificity of the joint-production c1wiro111 11e 11t c <J illCS fron1 thc foct tl rnt
- ;:::
rcwards and punishment~ are, by cldinition , collcct ivc and apply to both agents at thc
sanie time. This importan~ feat.ure of t he environmcm crcatcs strong incentives to frec-
ü !!.
"'
M '
TfJ
(Al 3)

ri<lc. Each ngr"r hrnrfi ts from t h<' ot lir:r< <>X<' rt i 11g n11 c-ffort wlwr<'M h<' brars nlonr thr
il - :!.!_ ;::: (A 14)
26 ·rr
cost of cxerting his own cffort. As more age nts are invo h·cd in team product ion 11nd he
T hc pri11cipD l's problcm in front of t wo a<; nts who pcrf t ly collude as auove becom
production e..'Chibits decreasi11g returns each agent fin ds the benefit of exerting his elfort
thus :
smaller compared to the cost. Th is hardens thc coaflict uctwccn incentive> and insurancc
(f>< ) : maxrr(S-2h(ü)) + (l -'if)~ - ~h(y_))
in comparison with the single agcnt cnvironment. ( 1(,.!!!_}

subje<:'t to (A13)-(Al4) t\ltd (A ).

R e m ark: The fact that rewards and punishmcm s are collcctivc has also ;mportant iJu-
plications on t hc scopc for collusion l>ctwocu the agents who werc so far supposed to Procecding as usual it i · >t nda rd to show t ha t th partidpatiou constrai 11t of each
adop t a non-coop rative behavior. Sinoc the shocks 0 11 their cornpcnsatioas are pcrfcctly agent (AS) a nd on of tl 1e crxdition i11ccnth·e coru;cro ints are always binding a t. th opti-
corrclatccl, t hcrc is no scopc for cxchan !ring sidc-transfcrs bctwccn the age nts in o rd r fo r mu rn .
f> By .. mote.. _ \\'(' mean hC're going from onc l o two agt•ut~- lt shouJ 1 be ckar lhllt aH tba r. i::. ~id hcrl' ~• \\'t> tl1u::, ~ume i.t\\"3)" any diflkuhy iu e1 1fon.:i11g a l>indiug <.."()U u:-;.ivc id. .'-cO 11.ract. IJctw1't' n th c .i:t.r,cnt.:,.
can be C".asily genct:a li7.ed to the ca.se of a team invo)viug r'.L agC"u l::, (n ¿_ 2). C\'l'n though thi!i. controct i::; illeg3l.
8.1. TllE PRJNCIPAL-MULTIACEXT .\ /ODEL \\.IT/I }QI NT PR0 D UCTI01'i l il 172CllA PTER MORAL lfA ZA IW IN TEAMS A ND TI/E FRE&IU Dt:// l' ll0 /JLEM

T he soluLiu11 to this problcm dcpcnds ne,·crthck~s 011 whcthcr thc global or thc lo-
cal iu(-eutivc constraínt is binding. 13oth cases are possiblc dependi ng on the as -umptions
mede on thc :;tochastic production functio11. ll owcvcr , to makc a straightforward compar-
ison with thc case of ra.sh bchavior wc will a.5Sume that thc tccbnology cxhibi ts dcc rcasing
returru;. i.c., r. + rr ::; 2iT. As wc sl1owc,'<.I in Scnion 8.1.2, thi.s is thc most rel vant case to
cxhiuil a free-rid r problcm when thc agcnts adopted a fully non-coopcra.ti rn l.Jchavior.
Then, th local inc<'ntive consuaint (i\ 14) is more costly tha n t hc global on (A 13) sincc
2,:,.,,- < i>T.. lndt-ed, it becomes quite valuablc for t he coalition to deviate by irnposinp; to
only one agent not to exert n effort. l3e<·a11se o[ dec reasing returns in the technology, lhe
incremental loss in tcrms of cxpcctcd bcncfit for the coalition fron 1 s ncl1 a lon1 l tJe,·iatíon
is relatively small compare<l to how 111uch it s.:ivcs in tcrrns of disutility.
Comparcd with Scction ,1.2, t hc d iffcrencc comes from t hc fac t that t he bcncfits
of this unilateral de,•itltion are now countcd for thc coalition and not for an individual.
Sincc t hc coalition internalizcs t hc ncgath· extcrnality tlwt a dcviatio11 by any agcnt
exert.o; 011 the ot her, it becomes easier to providc incentives to the coalition than to a 11
individual. lntuitively, the coalition betw..en thc agern.s hclps in prcvcnting thc frec-ridcr
prol.Jl in that would ari e with t hc agcnt · adopting a Nash bchavior. lore for r11 ally, thc
coalition incentirn constraint (Al4) is less costly than thc individual inccnti"c coru;traint
(A 7) bocause i,: is replaced l.Jy ~ on the right-ha nd sidcs of thcse respecth·e constraiuc.s.
in monitoring the proYision of inpuLs by the team mem l crs. l li: own i11ccntiveo o do so
Rre the11 ol.Jtaint'<.! by rua king him residual cluirnant for thc production o[ the firm.
To better understand th role of thc pri11 ci pal as pro,·iding monitoring, lct us in,·cst i-
ga tc thc \1:l.lue for hiw uf lcanliug a :;ignal wlüt.:11 u1H.)' be i11forr 11ut,í ve 011 the agl!nt:s' cffort.
J--'or sim pl íci t.y, a11d c.C:i c.m cxcrd -e to gcncralizc our prc,ious rcsults wc will assumc that
1
lxith agcnts are ri.sk-ncutral but protected b)· limit.ed liability.
Suppooe for cxamplc that thc pri ncipal obscr\'cs R vcl"i fi al>lc si na\¡:, E {o 1, 02} which
may respocci\'e\;: be cither "'good" or "bl1d ncws" on thc agcnts having both cxerted R
high effort. We asS1 1me tl1flt :
1
f' r(od both excr\ cffort) 110 2: 2
Pr(<7 il i[ <ll lcast on<' docs not cxcrt cffort) 1 - 1'" - ~
...,, < 2'
Bnd o 2 ariscs with thc tompl mcntary probabilities. Note that thc cutting edgc va luc
I' =4corrcsponds to ehe case whcrc t he signa! O- is not informativc.
ln ful! gcnerally, t h contract l (q, a) o f cach agent is now cond itional on both thc
k v>I of production q and thc rcalization of thc signa[ 0-. Lct us denote t hc corre:-;¡)011di11g
tra n:::;fcr::; as:

Wit h collusion , the collective re"·ards and pu11ish111cnts are now thus givcn by:

(A 15)
Al! those t rn rn;[crs must rcrnain positi vc to rcspect. t he agc11ts' lim ited liabifüy co11-
stra int.s:
This leads toan exprcssion of th<' total i111 µ\ erne1Jtation cost undcr mora l hazard \\'hich
[,. [,, [,' fa 2: o. ( l 7)
is:
~ . ( , n:,.'
2
r;f{l - r.),µ )
C =2 V'+2+ (A IG) Assuming that agents adopt " 'ash IJehavior, thcir indi,·idua l inccm h·c constrai nt ca n
41'.'.:-r' .
l.Jc writ tcn as:
Summarizing both cases, it is im111edia tc o show:
11<>(rrl1 + (1 - r.)1 1) + (1 - µo)(r.12 + ( l - r.)t,) - v
Proposition 8 .3 : Mutual obsen;ab1/1ty of cfforl.s and collusion bctwecn lhc agcnt.s i.• T" 2: (1 - ¡to)(irl1 + (1 - rr)t,) + /lo(irt2 + (! - ñ-)h) . (AI S)
fen-cd by llu: ¡!1'ttte>¡x1I. A; e:fl' rlmg co11111wii effort becomes more cro.ctal (ir d1min1shcs).
C"º - C' incrca.ses, and thc princ1po.I 's bcriefit from r-ec1procal observab1/ity rncrcasc" Thcir indi ,idual participation constraint boc·omcs

I' (irÍ1 + (1 - f.)~,) + (J - llQ)(ii[, + (1 - ir)h) - ,µ 2 o. (A.19 )

The Value of Monitoring

l1e free ridillg problcm discusscd in this scction has bcen par ti~ul arly e111plrn si%<xl by ,\ s usual, the partici r atio11 co11stra im is not rclc\'am under limitocl lia bi li ty' a nd (A 19)
Alchian Rnd Dcmselz ( 1972). They ,·iewcd frcc-riding as t hc majar problcm within firms ca n be ncglcctcd.
whcn therc is team production . Thcy argucd that thc main role of the 1mmagcr ('On.sists 1
\Ve lct l hc rieader check this as an cxC'rc~· to thf'· 'n._·ade r.
 _2_ M ORAL J!AZAfW J.V TE:\ .\IS 173 l 74Cl1A PTER M ORAL HA ZARD I N T El\MS :\ 1\D TIIE FREE-RJDER PROIJLCM

T he princip<tl 's problcm bccomes: 8.2.l A Simple Example

(?"): max ii - + (l - ii),l- 2 {µ 0 (iTl 1 + (l - ii)~ 1 ) + (l - µ 0 )(irl2 + (l - ii)f.:¡)} To illustratc somc of the issucs which may ari:;c v.itll t~ Uo pro<luction. wc revbit thc
(h.r 1 n.~-:}
simple n1od 1 of Se<'tion . Ll \Yith a stochastic prod uctio11 function . 'ow, wc assume
subject to (A 17) and (A LS). t hat ali procceds of production ha"e to be rcdistributcd bC"twccn the agcnts.

\Ve denote "º""

l>y {f. ,L.} thc inceuti " c sd1en10 of agem A,- T hc following ex post
The solution to (P") consists in puníshing as much as possible thc a ents if thcy buclget-balnncc const rain · must be satisfied :
collectivcly fail {f = f~ = Oand to rcward them in msc they sueC<.-ed and thc signa! lcarnod
011 the projecl is good 11ews, '1 = <r1. This is again a corollary of the "/nformativeness
s = l, + [,, (A22)
Princip/e''. 8 Thís i;; prcci<;cly whcn he principal has rcccivcd good ncws on thc projcct and
that a suc(-c:;s is the 1uost informati"e on the fact t hat uoth agcnts Jia,-e cxerted a high (A23)
elfort. Forrnally, we have:
Thcsc constraints stipulatc that ali thc procceds of productio n a re distri but.cd bctwccn
fº - t,J o (A20) teammat.es.
' - 1101' - (1 -1,o)fr
At R Na•h equilibrim11 with high cfforls, t hc agcnts' incent ive constraints ca11 110\\' be
writ tcn a:;:
This lcads to an cxprcs,ion of he '<'<'Ond-best cost o[ implcmcnting a high cffort pair ii[, + (1 - T.)t - ü 2: ir[,+ (t - f.)L. i = 1.2. (A2'l)
tmder the information structurc <T as
Finally, the agcm s' participation constra ints are:
(A21) T.l, + ( l - iT)L. - <? 2: o. i = 1, 2. (A25)

Let ns nppose that (A3 ) holds. i.e __ the firsl-best outcome re<¡uires " high cffort b.1·
As th signa! bccomcs more i11formn1ion, p 0 incrcasc:; abo,-c i. C 0
(¡10) dc'Crcascs and
Uuth ttgcHLs.
tlic µrioclµal ':s: t..'X]J(·•eted profi t iw. 1 cii.~t.':'i. A 11101c~ pn.--..:i.se !-)igu~I 0 11 t.hc .ag(' 1H,:'' dfmls
allows to rerlncc thr ngcn\y rost, ~[orr.ovrr. a..:; thc cr 11ciality of a ronunon dfort incrc; srs sing {A22), {A23) nd also (A24 ), " -e obtain aL<a:
(;i- dccr keepiug if fi xccl ), tlw <lifferenc<' betwrcn C"(Jlo) and Cº (~) also decrc"'5CS,
f!SCS , . - - 21/J
6.S = t, -1 1 + t2 - b 2: ó.rr . (A26)
meauing Lha t informRtive signals are of a lower marginal valuc for t hc principal as the
effort of each agent becomcs more esscntial to the production process. Cb1rly, thcr~ existo value:; of 6.S such tha t both (A:I) is satisfied but (A26) <loes not
hold . l n thb case, thc rc cxists a conllict bctwecn incentives and budgct-lx1lance. lt is
impo:;.,;ibk t o induce both age11t.; to exert a ltigh effort and to rcdistribute completely the
8.2 Moral Hazard in Teams procced o[ production l>ctwl~Jl thcm. Fro111 (A26), cach ageut gets only a fractiou of tbe
o\·erall inn mental bcnefits (T. - -ii )6.S of Pxerting a high effort _ Hence, e"-<"h "-gent ha.>
\\'e ha,·c already s~-en in Scction ' . l.l thc importa11cc of thc principal as a budgct brcaker lcss th1111 he social incent ives 10 cxcrt cffort _ As a rcsult , agcnts "fte~~ rid~" , cxcrt ing lcss
if one "''"" ' to implcmcnt titst-best dfort in t hl' coute."'1. of teRm product iou. ll1au t !tt first -l>c>l <;[ot L.

Let us now assumc t hat thc prindpal is a u 11crnlcnt maximizcr of the sum of thc Ue m nrk l: Note thal the ageuts' participatío11 constraint plays no role in thc inclfieicm',\'
agcuts' cxpc.-cl-e"<I utifüies. In a sens ., wc adopt thc ~lyerson and 'atterthwaitc (1983) rcsull found abo\'C. Only budgct-bala nce a nd incentive compatibility matter. The rcader
way of modding ba rgaining bctwccn thc tcammatcs. wil! ha ,·c noticcd thc para Ucl with wha t we aw in Chaptcr 3 whcn provi11g that Crovcs

ss~ l. . Affonl a.ncl ~fartimort (2002 , \ rohmw l , ChA.(llf'r 5) . rncchanisms ca1111ot in1pl<'111c11t tite first-lx-,;t and be uudg-ct-uah1necd i11 a pul>lic good
~ ~ote tha.t /'(Jfr - (1 - µ.o )#~ ~ > O wb€n /.Jo ~ ~ · c11,·ironmcnt \\'ith a (verse sclcction. •
8.2. i\1011..AL l/ AZARD f,\~ TL'AM 175 17GCll Al-'T¡.;R '- .\101/AL llA ZAJW JN TE.<\M ANO Tll E FR EE-RJDER PROBLEM

Proposit ion 8.1 : For f!i < S < f!:. there exisl.s no budgct-balanced incentive schcmc Wc "·ill ass umc tha t the tcam gcneratcs a positive surplus a t thc first-bcst:
which •< meen 1v com¡>a t<bie and i11duce firs t- bcs t efforl.s in a team.
,'(c · i - I:: ~" (<l >o.
1 ....:. I
(. ')
This propositiou shows the difficulty for a team to shnre the procee<ls of its member· -
cfforts whcn thosc cfforts are uouvcrifiablc. Two possiblc solutions to this probl<"1n are Thosc first- be:;t lcvels of elforts co11ld be i111plcmc11ted if eíforts \\'ere v .,-ifiaLlc by 11
ª '-aih1ble. Fir. 1, the agents muid use a third-parL.1' to break thc Ludget cons rain . This is Court of Law with 'impl fordng cont racts. Lct us t urn to thc case whcrc only thc
wl1a t happcncd in Scction 8.1.1. Anothcr possible solution is to forgct so 111ewha t allocativc aggregatc performance . · is ,·crifiablc so tlmt incuuti \· sd1cmcs can 01tly be condítioncd
cflicicncy a ud givc up tbc hope o f implcmcnting thc first -Lcst lcvcls uf dío rl. Thi> is Lhi> on tha t \<lriabl . \\'e define a dijfcn;11twb/,, ~lu.1m1g rnle as 8 11-\'C -tor o f diffcrc 11l1>1blc
S<..>oond-best route ihst '" will follow in Se<>tion .4 Lclow. fon t io11s {o 1(-),_ .. . o,,(-)} such that ex poot budgct balance is satisfice! for ali rcalizations
R eruark 2: Tlmt thc condit ion l:!. S ;:>: i;'º is alw. ntliri<"nf fnr i 111 plr1 0~ 111i11g n Nn"'u of the production íunCLion:
p rofilc with high efforls is almosl straightforward and is lcft to lhc rcadcr. • Ln,(S)=S. (A.29 )

Remark 3 : Let us consider thc case o í a t.eam with n agents, still dcnol ing by i\.;r =
or ali Sin t he range of S(-).
u(n) - ;r(n - 1) whcre ;r(k) dcnOtl';; thc probability of succes.s the n k agents exert a11
e ffort. . The couditio11 for i1nplmneut i1ig i:t ve tor with n agcnts C;'<c rt ing: high cffort bccmucs A sharing rule defi nes a gamc l o be playcd among thc agc nts. At a J\ ash cquilibri11n 1
S > ~ and is unlikcly to hold as n iucreases. Large lea111s are lll'<.:e:;,;arily ineflidcut .• rl - (é 1..... e,,) of this gamc, thc cffort lcvcl e, choscn by agcnt A, satisfics the cond ition :

e,= argrua xo.,(S (c.,c_,))- w, (e,) .

'•
8 .2.2 Differentiablc Schcmes
;\ ·u1 11ing conca\'ity of thc objcctiYc fum·tio n of A., we obt ai n the following first-order
In a · minal papcr , llolmstrom ( 19 2) initiated a li,·cly a nd importa nt debate o n the condition.':i:
ahiLity of a l e;un lo sh re a joinl produrlion while s till inducing efficiem effort levels. _ as _
,en)),,-(e, . .. e.)== 'i-';(e,), v, E { l .... , n} . (A30)
Cont rary to thc overly simplistic modcl o[ Soction 8.2.1, whi h cvcutually allows t he 6n;t- ue,
ucst to \;e i111 plc me11t ed, l l irn·ffwic1w . is more pcrvasivc whcn production f1111ction" nn rl
Taking into acconnt (A27), we obtr1in o:(s(e)) = 1 <1.t ti Kus l1 equili briu1u if =e· , e
inccn ti1'e schemcs rr assu mcd lo be con1inuou.> ly diffcrc11tiablc.
i.c., if thc Nas h cquil ibrium undcr srruti 11y implrnwnts r.h1· first-h .:;;t offotts. 111111 i1ivdy.
Considcr a productiou fu nction S(c1, ... . e,,) whi ch de pends on the effort leve) of 11 10 induce each agcnl t o cxcrt his first.-bc;;t cffort he must rcceil·c, at he margin , thc
tc<1111 mc111l;crs. Wc a&>uai e tha t. S( ·) is strin ly concavc in e= (c 1, • •• , en ) with !f;(c) >O wholc procceds of joi nt prodnclio11 . Oí course, it is i1u possible to makc ali agcut; rc,;idual
for ali i. l11d ivid ual cfforts :i.rc no t obse" ·ablc in a sccond-bcst cnvironmenl. claimant et thc same time. lndeed, wc would have ¿;·_, a:(S( ·' )) = n. 0 11 thc othcr

The lirst-best effort levels r ' = (rj, _. _, P~ ) are defined by

hand, diffc rcntialing (A29) yiclds ¿::__, a'.(S) = !; a cont radi tion.

F ínrtlly, wc obtaiu;
(e j ,. •. ,c;,)=arg nrn.x
( .... ., . )
(e ,, . . . ,e.. ) - L u.(e, )
Proposition 8.5 (llolmstrü111 ( 1!182)) D ijJen11tt(dJle hai-1119 n•les 11•/n c/1 fli'tl'll!J> bcrl<wce
,;vhere ,,J1 (e:1 ) is A ,·~ disntilit\' of etfui-t that wc a'}.Sume incrca:.ing nncl cou'-·i..:x . Thc n ec~­ thc budyll <:atttiol mducc tlw firsl- k> t leve/, of cffu1 l.
sary and snfficicnt first-ordcr rnnditions for optimality nrcJ tlwn gi n •n hy:
This mmlt can be ext ended to any type oí slmring rule (llol n1s1ri:itn ( 1992)) . lf t he
as . E { l , .. ., 11} .
-,--! ( , ... ,e:, )== .,;•:(e;) t ( 27) 1.ialanttd-budgel requircment is wcakencd to
(t'-¡

'ºChcn~ (2001) called thlb condition the "110 ~urplu.s ooudrticm".

11 \\11cn "'('ha,,.~ ~S > ~
) o,(S) :SS (A3 1)
· -1
8-2. .\101\.AL ll AZMW IN Tt:A.llS 177 l 7SCl/Al 'TJ::/7 .llOHAL ll AZARD !.\' TE!li\IS ASO 1·11¡,; Fl/ l:J&llIIJEH l' IWOLEAI

o ue can howcvcr <:o n:slruct discont.i nuous ~ h a.ring rules \Yhich are balanrcd ü-1 c.h • C(lui- Ra.smusen (1987) s howcd tha t. if agents a re enough rk;k-a,·orse or ha ,·c cnough wcalth ,
libriurn C\'C ll 1hough thc ·a re not bala nccd off th cq11ilibrium . Ta kc for instancc thc a mcc:hanism whkh randomly pu 11 i:ih0s an agcnt if thc first- best output b noL o bscr\'Cd
so-callc<I slwof-the m ali schon1c proposed by l!olmstrom (19 2) : ruay work. llowever. even thongh t he budgct i:; uow balanccd, this ra ndom mcc:hanism
still re<¡uire:; thc commitment to was t e wclfarc. A 11 assumption wbid.1 i" a:; problema tic
o, (S) = a, if S ;::: S(e; .... , e~) (A32)
as t hc cornmi tment to w is.te resourccs.
=O ifS < S(e j , ... ,c;,)
l.cgros a nd ~(atthcws ( 1993) a mi Vislie (199~) s howed that , if thc production fw1ction
with ¿;'_ , n, S(1·j ,. . ., e~) and a, > 1/1,(e;). Such ' 'CCtor (a 1,. .. . a,,) exists bcoiusc S(c 1. .. . , <'n) is 4"0ntidf. a sharing rule which r li utlnrt f' Ps the fr~ ridrr problern px_i:;ts .
(A28) holds. Again, it is bccause n agc·n t who d c,'ialcs from thc cfficicnt effort le\'el, ca n be induc(·d
to bear he full cost or his dC\' Íation. Sce a lso lll·id > (2001) 0 11 tlti~ point.
This mcchauism nwkc · cach agcnt be pi,-otal. lf A, d ,.¡Ates a nd exerts lcss than
tbe first- b ··i hm.,) o f ~fforl r;, he pr dpitat.cs a tc rrililc collcc1.ivc penalty; nobocly gets Anoth r liiw oí research con:;ists in to look for conditions which solv · the frce-ridc r
paid . Such downward dcviations a re thus not vahrnble. On the other hand. agcnt i docs problcm for st ochas t ic produ ction fu nctions a nd quasi-lincar utility funct.ions (see l!adner
nvt ckvit1lc a uon: thc fi,-,;t-uc:<t cffort C: gi,·cu tha t his l..tmelit fur sud 1 highcr cffort. is and \\' illiams ( 1995), and L~gros a nd Matsush ina ( 1991)) in niodels with a discrctc: num-
ron.s t ant and his dis utility grca t.cr than at <·
T hNcfon' . th <' firs t-b•':'l d f..,rrs rn n he ber o[ l'ffor1 and 1-Jrod nction l~wls . Thf' condi ions ar · obtained followi ng the n1el hoclolr>gy
impl rn nted a t a Nash cquililirium of this 111ccha nism . l\'otc although that this ~c·heme of IYAsp ren1ont and Gérn rd- Varct (1982) for ad\'e rsi; s lcction mode!; (seo D' Asprcmom
rcquircs thc crcdibílity of wastíng; t cam production if a ny Bgcnt dcviatcs. \Vith rntional a ud Gérorcl - \larct (1998) fo r a good s u1 11111ar ·). Tuc bcar s imultaneously on the util-
tllirrl ~ pttr ics 11SG"(I a.s bargaining mcdiat.ors are r· nf"cr11cd by building
agcnls t11)(l whe11 thc it y fuuct ious and on the distribution f11nd iOlL> aud "'e somewha t difficult to interprel.
reputation íor fln efüclenr u. e of resoutce-s, using uch a discont.inuous scherne 1wl.y 1hus Chcng (2001) provide; 3 ·'no surplus co11ditio11 " fo1 t hc Ml!>l fUUliliility of " " cflicic11t '.11 ash
be qui te proulcmatic. Abo, any mcc:ha nism that d ocs nm fully re<listribu tc production is cquilibrium w itb a more general stocha5t ic prod11ctio11 fu"':tion than tha t of Scction
not robust to rcnegotiation: oncean s g;ent has dc,'iatcxl and production is lcss than what .2. l. Finally, Bat aglini (2002) showed that thc firs t-b l efforL< r<1.n st ill lw i11dm•erl
is expected a t the firsl -best a collecti ,,e puaishment is pal'tic 11!11rly inefficient and agents with buugct,-bu \uncc if thc third-pa rty obse rves a multi-dimen;ionul output linkcd to thc
rnay want, t o renegotiatc Lo avoid t\'asting rcso urccs. agcnl s efforts.
•
ll oh nstrom ( l9'2) a rgued from thcsc rcsu\ts tha t a majar role of 111 a11agcr i · to
break the budgct a t least off t hc cq11 ilibriu 111 and not to be a supervi r of tb c 11g1•nt ~' 8.3 Optima] Seco nd-Best Teaiu Contracts
effort s as suggested by Akhian and Demselz (1972). This may be indccd a role played
l..y a manager, but in practico we do not scc panncrs in a project dcsigniug s haring rules As for free--riditvr with ach ·crsc sctcction 12 wc 11i n:s ~ rceoguize that 1 in thc intc re~"ti n g ca.ses
which attributc a largc pan of tcam product iou to a tliird-par y to crc-di bly rornmit o of stochas tic prod uction functions wi th risk-a\·crsc "gcnts, t he fi,-,;t- b ~ t is no t gcncrally
inrfficicncirs ~ t lc11.% off thr r q11ilibrinm. lnot M<l, IMntOln l <'-' m~v choosr to scll t heir · chic,11blc and thc el · ign of tC<1111 s haring rule m nst be statcd as a 'el'Ond-bes t prol.Jlen1
c11terpri to a 1hird-party which plavs thi.< role also on the cq uilibrium path . Tllli; is 1 it h budgct IJ¡1\ancc and inccnti,·e com patibili ty. Tlüs is t.hc t ask undcrtakcn in thc ncxt
preciscly th role of the principal in Sectiou 8.1.1. scct.ion.

Eswaran and Kot,va l ( 1984) criticir.ed Lhc role of t h ·manager as a budgct-brca ker a nd
arguc t hat thosc schcmcs may not be r bus t to s ide-coutrncting bctwccn this th ird-party 8.3.1 Ris k-Ave rs ion
and somc agcnts who would ,·oluntarily induce t hc penalty that thc ' could thcn sha rc
\\'ith the third- party. l IO\\' v r t his intuiti,·e insight rcquircs that thc agc11ts havc thc Lct us thus ucld rcss thc general problcm of t• partncr•hip which must sharc a randon 1joi nt
ability to rommit toan illcgal (and t hus hard to enfor(-c) sid(.,'-Contract . An ass umpt ion pn.11l11t'liot1 wi1c11 workcrs are rbk-.:=wcn;c.• tmd ('ffort s :;hould be cncouraged.
whiclt ma.y be <.:ouflicli11g with thc fat ct t hat agcn · are supp ~t'(i o !Je unnblc to comm il
To ~implify, wc \\·ill ag3 i11 üSSLlrnc that tcam production ca.11 only ri kc Lwo \·;_1 \ucs
LO an cnforceabl grand-co n"·act with collcn ivc punisluncnts as it has bcen poi 11t.ed out
by Andolfatta a ud i\osal (199 7). 11
&.~ Chaptc1· 3.