Abstract:

This paper investigates the problem of delegating decision-making when there are limitations on using monetary transfers to provide incentives, but the principal can prescribe costly activities such as bureaucratic paperwork on the agent for choosing certain actions. For simplicity, we assume that these activities are purely wasteful, and refer to them as money burning. Through the agent’s ex-ante participation constraint, the use of money burning is costly for the principal. Despite this, the optimal delegation contract can involve money burning, both when contingent monetary transfers are not possible, and when payments from the principal to the agent are bounded from below. We show that under certain regularity conditions the optimal contract in case of a positively biased agent imposes zero money burning in low states, money burning is increasing in the state, and the implemented action is always between the ideal points of the participants. If both transfers and monetary transfers are allowed, whether the optimal contract involves money burning depends on how important the action choice for the principal relative to the agent in monetary terms, and on the outside option of the agent relative to the minimal transfer. If the outside option of the agent is high enough, the optimal contract is efficient, and there is no money burning. If the outside option is low enough, there is money burning in almost all states. For an intermediate region of parameters, monetary transfers (positive incentives) are used in low states, while money burning (negative incentives) are used in high states. The results point out a distortionary effect of minimum wages not discussed in the literature: increasing the minimum wage makes it more likely that employers switch to socially inefficient nonmonetary incentives from financial ones.

Notes:

revision requested by the Journal of Economic Theory