9781118041581

Organizational Design 603

Asymmetric information introduces potential complications. Frequently,

the firm cannot observe and measure the worker’s effort or output (or both).

Let’s start with two pieces of good news.

If effort is observable, then the parties can always implement an optimal contract

even if output can only be measured approximately.

To see why, suppose that output depends not only on the worker’s effort but

also on uncertain elements beyond the worker’s control. (In the legal setting,

a complicated litigation case might take many legal hours to prepare and try

in court and still have an uncertain financial outcome.) In this case, the opti-

mal contract will specify the level of effort that maximizes the expectednet profit

from the relationship. As long as the worker complies with this level of effort,

he or she receives the stipulated monetary compensation. This is sometimes

referred to as a “forcing” contract. The contract terms are designed to force the

worker to take the optimal level of effort; otherwise the worker is penalized.

(Of course, both sides benefit from the efficient work agreement.) A second

result follows:

If output is observable and depends deterministically on effort, then the parties can

always implement an optimal contract even if effort is unobservable.

In this case, there is no way to observe the worker’s effort directly. However, by

observing the worker’s output, the employer can infer the worker’s effort. Thus

the employee will receive compensation if the output goal is met. (This is also

termed a “forcing” contract.)

Here is the bad news associated with asymmetric information:

If effort is not observable and if observable output is not deterministically related

to effort, then the parties will be unable to implement an optimal employment

contract because of moral hazard.

The stylized example in Table 14.3 demonstrates this result. The worker can

choose one of four effort levels—low, medium, high, or super—in order of

increasing disutilities. The additional gross profit attributed to the worker

depends probabilistically,not deterministically, on the level of effort. According

to the table, gross profits are uncertain (either $100,000 or $50,000), and rais-

ing the level of effort increases the probability of achieving the high-profit out-

come. Thus, higher effort increases expected gross profit on average, but the

employer cannot infer the worker’s effort level from the profit outcome. (Even

a super effort might result in a low profit result.)

If both employer and employee could observe effort, the parties would

implement an optimal agreement calling for higheffort. From Table 14.3a, we see

that high effort generates the greatest net profit, $40,000. Item 1 in Table 14.3b

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