Risk, Return, and Moral Hazard
Posted: 16 Sep 1999
In this paper, we study a principal-agent problem in which (1) the manager has private information about, and control over, the mean and variance of his outputs; (2) the manager?s outputs consist of a sample of independently distributed cash flows, all having mean and variance determined by the manager?s action choices; and (3) the principal designs a contract that both elicits the manager?s private information and directs the manager?s actions. This extension of the agency literature is practically important. In practice, managers can do more than merely exert effort to influence their firm?s output, as commonly presumed in the extant literature: they can additionally make mean-variance trade-offs when choosing among projects. So, the control problem principals face consists of getting their managers to make the "right" mean-variance trade-offs, as well as the "right" effort choices. Also, in practice, many control problems are design problems that naturally result in a vector of observations of the manager?s outputs: if the manger is a portfolio manager, the control problem involves portfolio choice, and the manager?s outputs are the successive returns on the portfolio; if the manager is an actuary for an insurance company, the control problem involves determining premium rates, and the manager?s outputs are the profits on the policies issued, etc. Finally, in practice, contracts often elicit managers? private information through the contracting process: "bottom up" and other participative budgeting processes are illustrative.
JEL Classification: M40, M46, D82
Suggested Citation: Suggested Citation