Moral hazard in work organizations: A comment on Gaynor,Eswaran and Kotwal,and Holmström

A key question in the economics of organization is whether it is possible to induce a group of employees to produce some quota of labor desired by the director of their organization. Holmström (1982) argued that it is possible to achieve the desired result via a simple incentive scheme. The essence of the scheme is to pay the employees only if they reach the quota; if they fail, the director is allowed to take what they have produced and use it for his own compensation. In response, Eswaran and Kotwal (1984) pointed out that because the director's compensation is smaller if the employees succeed in reaching the quota than if they fail, he has an incentive to bribe an employee to shirk, thus guaranteeing that the quota is not reached. The director, in other words, is subject to moral hazard. In a recent issue of Public Choice, Gaynor (1989) criticized the Eswaran-Kotwal argument by suggesting that it is possible to design incentive schemes which eliminate the director's moral hazard problem. In this note, we defend the Eswaran-Kotwal argument, and raise further questions about the assumptions upon which Holmström's incentive scheme is based.