Moral Hazard with Counterfeit Signals

November 15, 2011 In many moral hazard problems, an agent may manipulate the information that the principal observes. This type of fraud has attracted widespread attention in executive performance pay manipulation and public medical insurance fraud. However, fraud is possible but conspicuously absent in many other markets. For example, websites may defraud advertisers by inserting fake clicks on advertisements. Unemployed workers may circumvent government incentives by organizing fake job interviews. Security firms may cover up breakins that occur on their watch. These types of fraud only occur rarely. But this does not imply that fraud is innocuous in these cases, as the mere possibility of fraud may impose severe hidden costs. For example, consider the extreme case that fraud is costless and produces perfect counterfeits. Regardless of the contract that the principal offers, the agent prefers to mimic exerting effort. Anticipating this, the principal does not offer any contract to the agent. Therefore there is a complete market failure even though no fraud is committed. More generally, incentives may be distorted substantially by the agent being able to commit fraud. The question of the paper is, how does the possibility of fraud affect the design of incentives in moral hazard problems? In the model, a risk-neutral principal and a risk-averse agent face a dynamic moral hazard problem. The agent’s effort choice in the first period is unobserved, but it determines the distribution of signals realized in the subsequent periods. However, these signals are also not observed by the principal. Rather, the agent is able to suppress some types of signal, and replace them with a counterfeit signal drawn from an exogenous counterfeit distribution. The principal pays the agent each period, based on the signals she has observed to date. The agent has a dynamic programming problem to determine which signals to suppress conditional on the history of signal realizations. The principal has an optimal contract design problem, to choose the optimal payment policy to implement a target effort and fraud policy. ∗email : [email protected]