Moral Hazard and

Observability
Bengt Holmstrom
The Bell Journal of Economics (1979)

Overview
Studies Moral Hazard problem when agents effort
is unobserved.
Shows the optimal sharing rule is second best.
Using signals other than payoff improve welfare.
The signal has positive value regardless of its noise.
Findings have wide-ranging implications.

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Introduction
Consider an agent A works for a principal P.
Outcome determined by As effort and a shock.
Agents wage depends on the outcome.
Effort brings disutility to agent, wage paid brings
disutility to principal [principal-agent problem].
If effort observed along with outcome, can be
contracted away.
Usually called the first-best solution.

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Introduction
If not observed, we have info asymmetry.
Optimal solution is second-best.

Solution: Use (imperfect) signals to estimate effort.

In this paper:
Derive optimal sharing under asymmetry.
Optimal solution with additional signal.
When is additional information useful?

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Parameters
a - Agents action
random state of nature
x = x(a,) monetary outcome/payoff
F(x) cdf of x induced by
G(w) Principals utility function over wealth
H(w,a) Agents utility function
H Agents reservation utility
s(x) Share of x that goes to Agent
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Assumptions
Additively separable utility of agent: H(w,a) = U(w)
V(a), V > 0.
Payoff increases in agents effort: xa >= 0.
Above assn. => Fa(x,a) <= 0. [First order stochastic
dominance]
Agent is strictly risk averse: U < 0.
Principal can be risk averse or risk neutral: G <= 0.
P, A agree on the distribution of .

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Timeline
Principal offers a contract s(x).
If agent accepts, he puts an effort a before known.
a and one realization of determine outcome x.
Agent gets his share s(x), principal gets x-s(x).
If contract specifies other contingencies y, then
agent gets s(x,y).

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Payoff Alone Observed

Principals utility maximization:

Using the distribution of x:

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Without this, we have

the first best
optimum. If effort not
observed perfectly,
we assume Agent
maximizes his utility.

Payoff Alone Observed

Usual optimization yields:
Second best
solution.
When = 0, we
get the first best.

The paper shows that > 0 (Prop 1), second-best

solution is strictly inferior to first-best (Cor 2)
Need to provide incentives for increased effort,
so deviation from first-best.
x is used as signal to infer a, so dependence on x!
If a is better observed, can move towards first-best!
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An Example
a is repairmans effort, x monetary payoff = length
of time the machine remains operative.
1
2
G w =w, U w =2 w, V a =a , x~exp( )
a
2
Optimal sharing rule: = [ + 2 ]

And, = a3, a given by 4a3 + 2a = 1

First best solution: s(x)= 2, a = (2)-1
Taking = , we get the following graph:
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An Example

Welfare measure=0.56

Marginal return
from effort > 0

Welfare measure=0.75
Marginal return
from effort < 0
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With Additional Information

y is a signal observed by both parties.
Optimal sharing rule s(x,y) given by:

For the same outcome x, different realizations of y

give different payoff to Agent.
For a given y, if we infer less about a from x,
deviation from first-best should be minimum.
Dont penalize for actions beyond control of Agent.
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Example
Prob(failure) outside repairmans control ~ exp(1/k)
x ~ exp(1/a) and independent of above
If we cannot identify failure source, then:
If we can:

1 > 2 => costly to induce a particular action a

when y cannot be observed.
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When is information valuable?

Can we use some r.v. y always to improve
contracts?
Signal y is valuable if following is false:
Equivalently,
Above condition => x is a sufficient statistic for
(x,y) w.r.t parameter a.
x has all info about a and y adds nothing to it.

Prop 3: If y is informative, s(x,y) strictly Pareto

dominates s(x).
Efficiency gains independent of noisiness in y.
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Summary
When only payoff is observed, contracts are less
efficient.
Adding informative signal improves the contract.
Provides same incentives for effort with less loss of risksharing benefits.
Explains complexity of real world contracts

Further improvement possible by using y only when

outcome really bad. (Conditional Informative)
Results robust when agent adjusts a based on
expectation about .
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Implications
Managers are not held responsible for events one
can observe are outside their control.
Their performance is always judged against
information about what should be achievable given
the current economic situation (this is the additional
signal here).
Similarly, when a natural disaster destroys the crop,
farmers should not be held responsible for the
outcome (beyond optimal risk sharing).

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