Pareto-improving inefficiency

Abstract

This paper considers a simple moral hazard setting in which a project owner (or, more generally, a principal) hires a contractor (or, more generally, an agent) to operate her project. We show that a systematic increase in the agent's operating costs can increase either the principal's profit or the agent's profit. The combined profit of the two parties also can increase. Perhaps most surprisingly, the principal's profit and the agent's profit can both increase simultaneously as the agent's costs rise. In this sense, increased inefficiency can be Pareto-improving under plausible conditions.