Moral Hazard and Bargaining Over Incentive Contracts
21 Pages Posted: 21 Aug 2014
Date Written: July 31, 2014
This paper analyses bargaining over an incentive compatible contract in a moral hazard framework. We introduce the Kalai-Smorodinsky bargaining solution and compare the outcome with the commonly applied Nash solution. Whether worker’s effort is higher in the Nash or the Kalai-Smorodinsky solution depends on the agents. bargaining power. If agents have equal bargaining power, the contract in the Kalai-Smorodinsky solution yields a more efficient outcome and induces more effort. The social planner can mitigate inefficiencies arising in both bargaining solutions from the moral hazard problem and even achieve the first-best outcome by allocating the agents’ bargaining power. If raising the worker’s bargaining power is necessary to achieve the first-best solution, this increase must be higher in the Nash solution than in the Kalai-Smorodinsky solution.
Keywords: incentive contracts, moral hazard, Nash bargaining solution, Kalai-Smorodinsky solution, bargaining power
JEL Classification: C710, D820, J410
Suggested Citation: Suggested Citation