Tools: Bounded Rationality, Incomplete Contracting, Moral Hazard

To date we have taken apart the firm and examined where institutions offer no advantage over bargaining by individuals, or relying on the price mechanism.

We have seen two early explanations for institutions we call firms.

Coase: characterized as the absence of the price mechanism. Firm exists when it is less costly to direct economic activity by authority.

Alchian and Demsetz: classical firm arises because of a problem of metering production. Firm exists when team production makes it difficult to compensate inputs individually.

Moving forward, we are going to look at how incomplete contracting, bounded rationality, private information affect things. Theories which explain institutions as a result of contracting problems.


contract: an agreement through which trade is mediated. (does not have to written down)

complete contract: agreement which specifies the actions parties must take and transfers which take place under each possible contingency.

Arrow-Debreu environment is one of complete contracts -- all markets exist for all possibly state-contingent goods.

Imagine an employment contract that is complete...

Think about a rental agreement.

conditional on things breaking down, noisyness of neighbors, construction in neighborhood, how many sunny days, specifies what maintenance can be done and how fast.

bounded rationality: because contracting parties are unaware of all possible states of nature, and know that they unaware of them, they are assumed to act in a boundedly rational way. They maximize their utility conditional on their uncertainty about the future, knowing that events they may not have accounted for may occur.

(When I agreed to become a UCLA professor, I know that I was not accounting for all possible events that might affect my utility. For example, I did not know if I could find a nice apartment near campus. Or, I did not know or account for the extent to which the Simpson trial would affect my life.)

Almost no contracts are complete, both because of the costs of complete contracting, and because of bounded rationality.

Economic agreements are almost always incomplete contracts, in which actions and transfers are unspecified for at least some (possibly unforeseen) contingencies.

Furthermore, enforcement problems can make actions and transfers under some contingencies indeterminant -- even though they are stated in the agreement.

The fact that contracts are incomplete allows for opportunistic behavior, or opportunism.

[Incompleteness leading to "anticipated opportunism" often arises because it is costly for some party to verify the true state of the world -- asymmetric information.  Rather than devoting resources toward learning the true state of the world, we often rely on incomplete contracts.]

opportunism: self-interest with guile.

Usually, actions taken (or not taken) which affect the values of the contract to the other parties adversely.

examples: Opportunism is, of course, accounted for (anticipated) when contract is agreed upon. It represents welfare losses because parties are unable to commit not to be oppotunistic. Opportunism often arises because of the private information held by one or more parties.

This can be information about ones own attributes, the true state of the world (inside info), one's own actions, etc.

The task is to design institutions that are "incentive-efficient"

We know that we can't get "first-best" because of contracting problems such as bounded rationality and private information.

We want to devise institutions that do better under these conditions than one-to-one bargaining or relying on the market price.

We saw some of this in Alchian and Demsetz.

Workers have private information about their own effort levels which firms/managers/owners cannot costlessly observe. Institution arises which mitigates this.

Parties seek institutional arrangements which limit the costs associated with incomplete contracting.

Moral Hazard: post-contractual opportunism.


contract actions uncertainty payoffs

taken resolved

consider insurance, employment examples


1) you sign a contract with a company that promises to fully compensate you if your car is damaged or stolen. You, in exchange, pay a fixed fee.

2) You then choose where to park and how to drive your car.

3) uncertainty: accident? car stolen?

4) Payoff: you give insurer x if it is not damaged or stolen (your premium); insurer gives you y if it is.

Contract does not fully resolve incentive conflict. Contracting on outcomes rather than (unobservable) effort. 

Incentive conflict becomes a problem because you bear the full costs of any effort toward care in driving, etc., but you do not reap the full benefits. Therefore, you will take less care. 


1) you agree to supply labor/manage a 7-11.

2) you decide how hard to work, and toward what ends. 3) randomness: how much did people spill, how busy was the store, demand for the goods they suppply.

4) output: sales

If agent's actions are costlessly verifiable to a 3rd party, no moral hazard problem. (But who monitors the monitor? How can we be sure the monitor is trustworthy and not colluding?)

Moral hazard is one example of a principal-agent or agency problem. One individual must induce another to at in their interest when performance is not perfectly observable. 

moral hazard within firms:

incentives of owners and workers are not perfectly aligned because workers bear the full cost of their effort but to not get full benefits.

since effort is costly, and there is opportunity for workers to divert firms' resources for private gains, there are moral hazard problems.

ex: workers shirking, taking office equipment for personal use, managers diverting resources to promote own department, using company planes for personal use...

any activity that diverges from profit maximization. 

Institutions designed to limit moral hazard: you also need the consequences you threaten to be credible. For example, if labor markets are perfectly competitive, firing someone does not affect them -- they just instantly find another job at the same wage. Problem: third-party enforcement, and agreement must be verifiable or else incentive to renege. exposes individuals to risk.

if not done right, could create perverse incentives....

(Why would you not pay a basketball player a function of the amount of points he or she scores? Misallocation of effort in games and practice. Incentive for coach not to play him in some circumstances where it would be efficient for him to play.)

(What about paying golfers a function of their score? Looking narrowly, the incentive properties are good. Only works, though, if it is predetermined when or where they are playing. This could cause them not to wish to play in difficult conditions.)

Analogously, paying workers piece rates can create incentives to lobby supervisors to give them the best working conditions -- give me the new tools rather than the old ones, let me work with the best workers, not with the newer ones who need to be trained.