Posted by: Martin | May 29, 2011

Moral Hazard and Taxi Contracts

It’s not my taxi anyway

I came across a Stanford University paper on motorcycle taxis in Togo and Benin, and particularly about the moral hazards linked to the contractual arrangements between owner (principal) and driver (agent).

In the standard moral hazard problem, it is often assumed that the output is observed and thus the compensation scheme relies directly on the observed output or an observable that correlate with the output . However, in many marketplace contracts in developing countries, this mechanism is not applicable. In particular, in the market of motorcycle taxi in Sub-Saharan countries, both the output and the effort are not observed. Yet, two type of contract coexist, one is a lease with a promise of transfer of ownership and the other being a simple lease arrangement. The Lease with Ownership ( LO henceforth) basically consist of reselling the motorcycle to the rider at a price on average twice its original value. They then agree on a weekly minimum payment. The rider becomes the owner only when she finishes paying the entire amount initially agreed upon. With the Simple Lease ( L henceforth) a daily fixed amount is agreed upon and the rider has to pay that amount everyday whether he makes more or less than that amount.

This sector has given rise to moral hazard problems. Those who own the motorcycles usually are not the drivers themselves. However, the drivers enter in a bilateral contract with the owners. Therefore, as in the case of workers in a firm, moral hazard problems emerge. The reason is that, there is practically no way the owner can observe or precisely predict the behavior of the agent. In general, in a standard moral hazard problem, the principal observes the output and base the compensation on it. Here, the principal cannot observe the output.

There are no moto-taxis in Abidjan as discussed over at Drogba’s country, but the exact same issues as above apply for regular taxis.

I talked to an owner of a taxi in Abidjan who said that he drove the taxi himself for a day just to observe the daily revenue.  The driver was claiming that the daily revenue was in the 30,000 to 35,000 CFA Franc range,  but the owner got 45,000 CFA Franc for the day he did the driving.

The study says:

A key feature of this market is that the agent has a full discretion about the revenue earned and he has the incentives not to
disclose the revenue truthfully.

Indeed.

According to the study, if the probability of the mototaxi being damaged so it no longer produces revenue due to the driver putting in high effort, is greater than a certain level, then the principal should choose the Lease with Ownership (LO) contract.  The optimal contract is that the principal chooses LO, and the driver puts in lower effort increasing the life of the mototaxi and thus the residual value he will receive.

Moto-taxis in Nigeria

However, empirical data from Togo and Benin show that contract type L is prevalent and that the more the owner trusts the driver the likelier it is that the owner chooses L. Basically the owner trusts that the driver won’t over-use the mototaxi even though the driver would gain financially by over-using it. What factors make the owner trust the driver is an interesting question by itself, the study has the following to say:

Both experimental and survey studies by Glaeser et al. (2000) suggest that trust and trustworthiness increase as the individuals have closer ties and, decrease when they are from different nationality, race, ethnic group or family.

Having known each other for a longer time, having had previous professional relationship, or being from the same ethnic group tend to favor significantly the choice of L.

So,  for a westerner doing business in Africa, this is part of what makes it challenging.

Anyhow it turns that in this case, looking at data from Benin and Togo, trust doesn’t matter for the driver’s behaviour, he will over-use the mototaxi anyway.  Apparently the economic incentives trump family ties, ethnic ties, long-standing professional relationships and all the rest. In this case a high level of trust just causes the owner to choose a sub-optimal contract.

From what I have heard it seems that the LO contract is standard for taxis in Abidjan, so maybe the lesson of this study has already been learnt.

P. J. O’Rourke’s take

Not sure it’s been learnt in New York though:

In a closely related work from the New York City taxi market, Schneider(2010) showed that moral hazard account to a great extend for the accidents, driving violations, inspection failure.

Which is surprising because there is an American author; P. J. O’Rourke, that nailed this whole issue back in 1986:

Even more important than being drunk, however, is having the right car. You have to get a car that handles really well. This is extremely important, and there’s a lot of debate on this subject – about what kind of car handles best. Some say a front-engined car; some say a rear-engined car. I say a rented car. Nothing handles better than a rented car. You can go faster, turn corners sharper, and put the transmission into reverse while going forward at a higher rate of speed in a rented car than in any other kind. You can also park without looking, and can use the trunk as an ice chest. Another thing about a rented car is that it’s an all-terrain vehicle. Mud, snow, water, woods – you can take a rented car anywhere. True, you can’t always get it back – but that’s not your problem, is it?

P. J. O’Rourke, from the “How to Drive Fast on Drugs While Getting your Wing-Wang Squeezed and Not Spill Your Drink” chapter in Republican Party Reptile, published 1986

P. J. has disappointinly but probably wisely cut down a bit on the wild and crazy since 1986

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