Using Both Sociological and Economic Incentives to Reduce Moral Hazard

By Richter, Francisca G-C; Diaz, Edgar F. Pebe et al. | Journal of Agricultural and Resource Economics, August 2003 | Go to article overview

Using Both Sociological and Economic Incentives to Reduce Moral Hazard


Richter, Francisca G-C, Diaz, Edgar F. Pebe, Brorsen, B. Wade, Currier, Kevin, Journal of Agricultural and Resource Economics


Economists tend to focus on monetary incentives. In the model developed here, both sociological and economic incentives are used to diminish the apparent moral hazard problem existing in commodity grading. Training that promotes graders' response to sociological incentives is shown to increase expected benefits. The model suggests this training be increased up to the point where the marginal benefit due to training equals its marginal cost. It may be more economical to influence the grader's behavior by creating cognitive dissonance through training and rules rather than by using economic incentives alone.

Key words: grading, incentives, moral hazard, norms, social sanctions

Introduction

Today more than ever, agricultural processors demand commodities that meet strict quality standards and, furthermore, commodities that have been accurately graded by quality. Processors seem more aware of the detriments of quality uncertainty. In a study of international grain markets, Wilson and Dahl found quality uncertainty can increase costs for buyers, processors, and grain handlers. Quality grades can also affect sorting and blending strategies.

Recent studies by Kenkel and Anderson in wheat and Pebe Diaz in peanuts have reported inaccuracy in grading due to graders not following directions. Brorsen, Grant, and Rister also found that hedonic prices for rice varied across locations due to differences in graders. Some graders do not follow official grading procedures because their individual incentives differ from those of the grading agency.

Economists have focused mainly on whether grading standards accurately measure the economic value of the commodity (e.g., Hennessy and Wahl; Adam, Kenkel, and Anderson). Scientists in other disciplines have examined the physical measurement of quality factors (Powell, Sheppard, and Dowell), but no research has been conducted on the incentives faced by individual graders.

A principal-agent model is developed here to explain how both economic and sociological incentives can lead to improving the grading procedure. Principal-agent models are commonly used to determine the form of optimal contracts (e.g., Wu and Babcock; Lajili et al.; Allen andLueck). The power of sociological incentives can be increased by training programs emphasizing the cost of not following directions and by administering psychological tests designed to identify graders who are prone to rule-following behavior.

The grader is assumed to be motivated by sociological incentives such as recognition and praise which add to the subjective or psychic income (increasing self-esteem) arising from doing a good job. According to neoclassical theory, the grader maximizes expected utility. The grader, as a rational economic agent, is motivated by economic incentives such as increased wage income and more hours of leisure. In addition to the economic incentives, nonmonetary, sociological incentives may also influence the grader's utility.

Moral Hazard in Grading

Standard agency theory deals with asymmetries of information that develop after the signing of a contract. Two types of informational problems arise: those resulting from hidden actions, and those resulting from hidden information (Mas-Colell, Whinston, and Green). Hidden action is the problem considered here. An example of the hidden action case, also known as moral hazard,1 is illustrated by the inability of U.S. Department of Agriculture's Federal/State Inspection Service (hereafter denoted simply as USDA) to know the real capabilities of the grader or to observe whether the grader precisely follows grading procedures-i.e., the grader's effort levels are not observable. Hence, the USDA has an informational disadvantage. This problem is referred to as "nonobservability" in contract theory (Strausz).

The primary difficulty within the grading procedure is the existence of a moral hazard problem, which involves an incentive conflict between the USDA (principal) and the grader (agent). …

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