DP6011 Optimal Incentives under Moral Hazard and Heterogeneous Agents: Evidence from Production Contracts Data

Author(s): Pierre Dubois , Tomislav Vukina

Publication Date: December 2006

Keyword(s): agency contracts , heterogeneity , moral hazard , optimal incentives , risk aversion

JEL(s): D82 , K32 , L24

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP6011.asp.asp

The objective of this paper is to develop an analytical framework for estimation of the parameters of a structural model of an incentive contract under moral hazard, taking into account agents heterogeneity in preferences. We show that allowing the principal to strategically distribute the production inputs across heterogenous agents as part of the contract design, the principal is able to change what appears to be a uniform contract into individualized contracts tailored to fit agents' preferences or characteristics. Using micro level data on swine production contract settlements, we find that contracting farmers are heterogenous with respect to their risk aversion and that this heterogeneity affects the principal's allocation of production inputs across farmers. Relying on the identifying assumption that contracts are optimal, we obtain the estimates of a lower and an upper bound of agents' reservation utilities. We show that farmers with higher risk aversion have lower outside opportunities because of lower reservation utilities.