9781118041581

lists the results of a high-effort contract. The firm pays $60,000 in salary to the

worker if and only if the effort level is high, thereby claiming slightly more than

half of the available net profit for itself. (In general, the exact wage bargain

struck, perhaps higher or lower, would depend on labor market conditions.)

Now suppose that the employer cannot observe effort. The employer’s nat-

ural concern is that the worker will choose a low level of effort (thereby mini-

mizing disutility) while continuing to pocket the $60,000 salary. The employer’s

concern is justified. Absent any other incentives, low effort is exactly what the

worker will choose. The potential divergence between the employer’s and

worker’s interests is the essence of the moral hazard problem in the employ-

ment relationship. This outcome is shown in item 2 of Table 14.3b. The upshot

is that the employer’s expected profit is reduced to $0, and the parties’ total

expected profit falls to $25,000.

What can an employer do? One option is simply to anticipate low effort

and adjust the salary down to $45,000, securing a $15,000 net profit from the

employment relationship. This outcome (item 3 of Table 14.3b) is better than

$0 but still far short of the $25,000 that is possible under a perfectly enforce-

able fixed-wage contract. A second option is to offer an incentivecontract. What

if the employer offers to pay the worker a base salary of $10,000 plus one-half

of all gross profits the employee generates on the job? Does this profit-sharing

604 Chapter 14 Asymmetric Information and Organizational Design

TABLE 14.3

Employment

Contracts (a) Effort and Profits

Gross Profits Expected Expected

Effort Level $100K or $50K Gross Profit Disutility Net Profit

Super .8 and .2 $90,000 $60,000 $30,000

High .7 and .3 $85,000 $45,000 $40,000

Medium .5 and .5 $75,000 $39,000 $36,000

Low .2 and .8 $60,000 $35,000 $25,000

(b) Different Contracts

Effort Employer Worker Total

Level Compensation Profit Profit Profit

Observable Effort

1. Forcing contract High $60,000 $25,000 $15,000 $40,000
   Unobservable Effort


2. Fixed wage Low $60,000 $0 $25,000 $25,000


3. Fixed wage Low $45,000 $15,000 $10,000 $25,000
   Incentive Pay


4. (1/2 Profit $10,000) Medium $60,000/$35,000 $27,500 $8,500 $36,000


5. (Profit $25,000) High $75,000/$25,000 $25,000 $15,000 $40,000

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