Other‐regarding principal and moral hazard: The single‐agent case

• Date: 01 September 2017
• DOI: http://doi.org/10.1111/ijet.12131
• Author: Mainak Sarkar,Swapnendu Banerjee
• Published date: 01 September 2017

doi: 10.1111/ijet.12131

Other-regarding principal and moral hazard:

The single-agent case

Swapnendu Banerjee∗and Mainak Sarkar†

Using the classic moral hazard problem with limited liability, we characterize the optimal in-

centive contracts when first an other-regarding principal interacts with a self-regarding agent.

The optimal contract differs considerably when the principal is “inequity averse” vis-`a-vis the

self-regarding case. Also the agent is generally (weakly) better-off under an “inequity averse”

principal compared to a “status seeking”principal. Then we extend our analysis and characterize

the optimal contracts when both other-regarding principal and other-regarding agent interact.

Key wor ds other-regarding preference, self-regarding preference,inequity averse,

status seeking, optimal contract

JEL classification D86, D63, M52

Accepted 24 February 2016

1 Introduction

Standard economic theory, from its very inception, assumes that all economic participants are self-

interested. This standard assumption, although meaningful in many circumstancesmig ht not always

be true. People are not always motivated by their own gain maximization; instead we often do

care about others and react in fair, altruistic ways. Unfair distributions of wealth or consumption

and relatively unequal payment structures do make us worried. From Guth et al. (1982) and their

famous “ultimatum game”experiment to recent social experiments by Camerer (2003), experimental

evidence from various quarters has proved the existence of other-regardingpreferences in behavioral

decision-making.1In fact relaxing the self-regarding hypothesis is crucial for contract theory since

the aim is to design appropriate incentives, and therefore people’s attitude towards others’ well-

being as well as their own well-being is crucial for incentive design. However, so far not much

work has been done to see how classical contract-theoretic predictions change in the presence of

other-regarding preferences.In this paper we tr y to analyzehow participants interact in the presence

of interdependent (other-regarding) preferences and how the conclusions obtained deviate from

the standard case of self-interested participants. Specifically, we focus on the case where there is

hidden action and an other-regarding principal interacts with first a self-regarding agent and then an

other-regarding agent. The agent is income-constrained, implying that a limited liability constraint

∗Department of Economics, Jadavpur University,Kolkata, India. Email: swapnendu@hotmail.com

†Department of Economics, Jadavpur University,Kolkata, India.

We would like to take this opportunity to express our gratitude to the anonymous referee for insights and detailed

observations that led to substantial improvement in the quality of this paper.We are also extremely grateful to the Editor,

Prof. Makato Yano, for giving us the opportunity to revise and resubmit the paper.

1For a comprehensive survey of these experimental studies see Fehr and Schmidt(2003).

International Journal of Economic Theory 13 (2017) 313–326 © IAET 313

International Journal of Economic Theory