15.4 Using Contracts to Reduce Moral Hazard

A verbal contract isn’t worth the paper it’s written on.

A skillfully designed contract that provides the agent with strong incentives to act so that the outcome of any transaction is efficient may reduce or eliminate moral hazard problems. In this section, we illustrate how several types of contracts can increase efficiency in the Paul and Amy ice cream shop example. These contracts provide greater incentives for Amy, the agent, to work hard, but often require her to bear some risk even though she is more risk averse than Paul, the principal.

Fixed-Fee Contracts

We initially considered a fixed-fee contract in which Paul (the principal) pays Amy (the agent) a fixed wage, with the result that Paul bears ...

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