Incentives and informal networks

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Working paper
Constanza Fosco, Friederike Mengel
Issue number: 
Maastricht University
We study a static model of principal-multiple agents with hidden actions (moral hazard) and local positive production externalities between agents. Agents interact through a given network of informal contacts, where links are interpreted as mutual advise or peer effect. Consequently, individual outputs will depend positively on own effort and nearest neighbors’ efforts. As the principal only knows which kind of network prevails, but ignores the exact position of each agent, an additional problem of adverse selection arises. We restrict wages to be linear in individual output. Under risk neutrality and absence of limited liability constraints, the principal achieves (almost) the first best if either he observes efforts or knows the position of each agent in the informal network. The combination of hidden efforts and asymmetric information, though, yields inefficient results. Analyzing some paradigmatic network structures, we find that at the optimum the principal will offer a self selecting menu of contracts, although there may be less than perfect revelation. Which and how many types the principal will be able to distinguish depends heavily on the structure of the network and the strength of peer effects.
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