Moral Hazard with Network Effects

TL;DR

This paper analyzes how a principal optimally incentivizes agents in a network with peer effects, revealing a new centrality measure that guides incentive allocation to maximize effort and productivity.

Contribution

It introduces a novel network centrality measure capturing incentive spillovers and characterizes optimal contracts in a network with heterogeneous agent costs.

Findings

Central agents receive higher incentives under optimal contracts.

The new centrality measure accounts for direct and indirect peer effects.

Positioning low-cost agents centrally enhances overall effort.

Abstract

I study a moral hazard problem between a principal and multiple agents who experience positive peer effects represented by a (weighted) network. Under the optimal linear contract, the principal provides high-powered incentives to central agents in the network in order to exploit the larger incentive spillovers such agents create. The analysis reveals a novel measure of network centrality that captures rich channels of direct and indirect incentive spillovers and characterizes the optimal contract and its induced equilibrium efforts. The notion of centrality relevant for incentive spillovers in the model emphasizes the role of pairs of agents who link to common neighbors in the network. This characterization leads to a measure of marginal network effects and identifies the agents whom the principal targets with stronger incentives in response to the addition (or strengthening) of a link. When the principal can position agents with heterogeneous costs of effort in the network, the principal prefers to place low-cost agents in central positions. The results shed light on how firms can increase productivity through corporate culture, office layout, and social interactions.