335
the manager’s expected gain but leaves the expected social profit V equal to
0.5A–10, which is positive only if A>20. Thus, even with punishment, society
at large cannot gain from this project when the manager has no valuable col-
lateral.
On the other hand, society at large could benefit from this project with
punishment if the participation constraint were dropped. In the pure egali-
tarian case where A=0, society at large could use w=0 and z > 120 to satisfy
the moral-hazard constraint and get an expected social profit of 20 in our
numerical example. But this seems a terrible solution, as it would correspond
to drafting an unwilling manager and motivating him to work hard only by a
threat of bodily harm if the project fails.
So our analysis of this simple model of moral hazard in production is
enough to show how industrialization under Soviet communism may have
necessarily entailed either the creation of a privileged managerial elite or the
use of coerced labor from prisoners of the state. Some insights of this model
may be implicit in some of Hayek’s informal intuitive arguments, which he
could express verbally
5
but which tended to get lost in his analysis as they
could not be expressed formally in the economic models of his time.
4.1 An analogous adverse-selection problem
To compare moral hazard and adverse selection, we might consider an ana-
logue of the above problem where the incentive constraint is about the man-
ager’s hidden information rather than about the manager’s hidden action. In
this analogous adverse-selection example, the project’s probability of success
depends on the managers hidden type, which may be good or bad. The pa-
rameters (p
G
, p
B
, R, K, A) all have the same interpretation as above, except that
now p
G
[or p
B
] denotes the conditional probability of success when the man-
ager knows that he is the good talented type [or, respectively, the bad incompe-
tent type], which is now a given fact that only the manager knows (but does not
depend on any choices that he will make). Suppose that p
G
R > K > p
B
R, so that
the project would yield a positive expected net profit for a good manager but
not for a bad manager. The outside investors of society at large are uncertain
about the manager’s true type. Let α denote the probability that the manager
is the good type.
In an incentive-compatible mechanism, we can ask the manager his type,
and then plan to undertake the project with some probability q
G
if he reports
the
good type or q
B
if he reports the bad type. If the project is undertaken,
the wage that he receives in case of success could also depend on his report,
being w
G
if he reported “good” or w
B
if he reported “bad”. We may assume
that if the project is undertaken and fails then the manager will forfeit his
collateral A. Under such an investment plan, the expected profit for the in-
vestors would be
V = α q
G
[p
G
(R – w
G
) + (1–p
G
)A – K] + (1–α)q
B
[p
B
(R – w
B
) + (1–p
B
)A – K].
5
For example, see Hayek (1935) p. 237.
336
An incentive compatible plan must satisfy the resource constraints
w
G
> –A, w
B
> –A, 0 < q
G
< 1, 0 < q
B
< 1;
the
participation constraints that neither type should expect to lose by partici-
pating
q
G
[p
G
w
G
– (1–p
G
)A] > 0, q
B
[p
B
w
B
– (1–p
B
)A] > 0;
and the
informational incentive constraints that neither type should expect to
do better by lying
q
G
[p
G
w
G
– (1–p
G
)A] > q
B
[p
G
w
B
– (1–p
G
)A],
q
B
[p
B
w
B
– (1–p
B
)A] > q
G
[p
B
w
G
– (1–p
B
)A].
Under socialism, an optimal investment plan should choose (q
G
,q
B
,w
G
,w
B
)
to maximize the expected profit V for society at large, subject to the above
constraints. But this problem is easy to solve. Even when the manager has no
collateral A=0, the allocatively-efficient ideal plan with q
G
=1 and q
B
=0 (financ-
ing good managers but not financing bad managers) is feasible with w
G
= w
B
= 0. That is, society does not need to pay anything more than the manager’s
normal cost of time, and the manager has no incentive to lie about his type to
get the project funded because he gets no special benefit from managing it.
But under capitalism, competition among investors to finance promising
entrepreneurs implies that, in a market equilibrium, uninformed investors
cannot make positive expected profits from financing the project. That is,
the equation V = 0 is an essential property competitive equilibria under capi-
talism. Then with A=0, the ideal (q
G
= 1, q
B
= 0) is not feasible in any incen-
tive-compatible equilibrium where V=0 is satisfied.
6
So a potential advantage
of socialism here is that a socialist state’s monopoly of capital can facilitate
honest communication, as bad managers cannot gain from imitating good
managers if neither type gets any profits from entrepreneurial management
(see Dewatripont and Maskin, 1993).
Thus, in our moral-hazard example, where the problem was to motivate
hidden actions, we have found disadvantages of socialism; but in our adverse-
selection version of the example, where the problem is to elicit honest reports
of hidden information, we have found potential advantages of socialism. In
comparison with free-market capitalism, socialism allows individuals to have
less private property rights. Giving an individual ownership rights over prop-
erty can help solve the moral-hazard problem of getting him to exert hidden
efforts to manage the property well, but such individual ownership rights
also give people different interests which may make it harder for them to
communicate honestly with each other, thus exacerbating the informational
6
This is why this adverse-selection example is interesting enough to be analyzed in section 6.2
of Tirole’s (2006) corporate-finance book, where competitive financing is assumed.