Moral Hazard of the Principal and Loss of Efficiency

Abstract

In an organization with multiple agents, moral hazard occurs not only for the agents but also for the principal. When the actions of the agents are verifiable, the principal may have ex post incentive to renegotiate with some agents after the original contracts are written. Then, the principal has no commitment power to the original contracts, and thus, the original contract must be rewritten to reflect this renegotiation. It is shown that principal may not be able to achieve the first-best out come because of his own moral hazard.