Moral Hazard with Sequential Policy Making ∗

We develop a moral hazard model of sequential policy making. Consistent with empirical observations, equilibrium behavior by the agent overemphasizes the late stages of the policy-making process. The reason is that the principal faces a kind of political time inconsistency problem because of the temptation to revise her retention rule in the middle of the policy-making process. If the principal knows the production technology for policy outcomes, then she can solve this time inconsistency problem (and the distortions it induces) by committing to task-specific budget caps. However, if the principal is uncertain about the production technology, such task-specific budget caps introduce ex post inefficiency. If the uncertainty is large enough, the principal may prefer an institutional environment where agent actions are non-transparent and the budget is fungible. Such an environment allows the principal to exploit the agent’s expertise about the production technology, but at the cost of weaker overall incentives. Hence, the model highlights a novel mechanism for why transparency may not always be optimal in political environments. ∗We have received helpful comments from Scott Ashworth, Cathy Hafer, and Richard van Weelden. This research was supported by NSF grants SES-0819152 (Bueno de Mesquita) and SES-0819545 (Landa) †Professor, Harris School of Public Policy Studies, University of Chicago, e-mail: bdm@uchicago.edu. ‡Associate Professor, Wilf Family Department of Politics, NYU, e-mail: dimitri.landa@nyu.edu How does the sequential nature of the policy-making process impact the efficacy of political accountability and optimal political institutions? Political economy models typically assume agents take only a single action prior to moments of accountability. However, in most important policy domains, an agent takes multiple, sequential actions between decisions by the principal regarding whether to reward or punish the agent.1 Moreover, empirical scholarship suggests the presence of important inter-temporal distortions in the behavior of policy makers. Most prominent among these is the well known pattern of behavior whereby principals primarily focus their attention on the later stages of the policy-making process and agents, consequently, allocate disproportionately more effort or resources to these later stages relative to the earlier stages (Popkin et al., 1976; Shepsle and Weingast, 1981; Weingast, Shepsle and Johnsen, 1981; Figlio, 2000; Rothenberg and Sanders, 2000; Albouy, 2011). Such dynamic effects cannot be captured in the context of a single-action model, and perhaps not surprisingly, they have resisted political economy explanations relying on rational agency.2 We develop a simple moral hazard model of political agency with sequential actions. Our model yields two key kinds of results that underscore the importance of explicitly modeling sequential policy making. First, our model gives rise to equilibrium behavior by agents that overemphasizes the late stages of the policy-making process. The intuition behind this result is a kind of political time inconsistency problem. The principal, at the beginning of the game, would like to commit to use a retention rule that induces an optimal division of resources across tasks. Following the early stages of the policy-making process, the principal is tempted to revise her retention rule in order to optimize incentives going forward. The agent anticipates this incentive to revise and consequently underemphasizes the early stages of the policy-making process. Second, we provide a novel argument for the potential benefits of eliminating transparency in political settings. This argument starts with the observation that, if the principal knows the production technology, then she can solve the time inconsistency problem (and the distortions it induces) by establishing task-specific budget caps at the ex ante stage, There are, of course, political economy models that consider multitask problems (Lohmann, 1998; Besley and Coate, 2003; Ashworth, 2005; Ashworth and Bueno de Mesquita, 2006; Gehlbach, 2006; Bueno de Mesquita, 2007; Bueno de Mesquita and Stephenson, 2007; Hatfield and Padró i Miquel, 2007; Daley and Snowberg, 2011), but none of these models consider the issue of sequential actions prior to a retention decision, which is our focus. The only other papers we are aware of that yield such behavior in equilibrium are Sarafidis (2007) and Muthoo and Shepsle (2010). In these models, the overemphasis of late stages of the policy-making process emerges due to the assumption that the principals have a “recency bias”, whereas in our model it is a result of purely strategic factors with fully rational principals.