Lecture 29: Moral Hazard

What the two discrepancies in knowledge between buyers and sellers:

Moral Hazards - hidden actions
Adverse selection - hidden characteristics

What is an example of Inefficient use of resources due to moral hazard:

an informed person takes advantage of an uninformed person through an unobserved action

What is a deductible?

provides an incentive for a person to take some care.

When is it that moral hazard occurs?

1. Mutually beneficial potential of interaction
2. Agent/Principal have different goals
3. Hard to monitor agents
4. Limited liability of the agent for actions

What is actions?

how well the agent works (how friendly is an employee to customers)

What is State of Nature?

- some external factors which affect profit but don't depend on agent's effort (example temperature)

What are the two efficient contracts?

Efficiency in production, efficiency in risk bearing

What is efficiency in production?

requires that principal's and agents combined profits/payoffs are maximized

What is an efficiency in risk bearing?

the person who minds risk the least (risk neutral or less risk averse person) bears more of the risk

A company can lend money to two alternatives: • Alternative 1: $100 mln with probability 75% and $80 mln with probability 25%; • Alternative 2: $400 mln with probability 25% and losses of $160 with probability 75%. The manager who makes the lending decision receives 1% of firms earnings. If the firm looses money they can just walk away and loose nothing; • What decision should the manger make if they only care about their own earnings? • What decision would be best for risk neutral shareholders?

Expected returns:
Alternative 1: 0.75100+0.2580=95 • Alternative 2:
0.25400+0.75(-160)=-20.
Income of the manager:
Alternative 1:
1% of 95mln = $950 000
Alternative 2:
1% of 400mln with 25% probability=$1mln

Shareholders prefer alternative 1

What is contingent fee?

No payment if the case is lost and some share of the award if the case is won

Lawyers use different constructs depending on

the type of the case

What is efficiency wage?

unusually high wage that a firm pays a worker as an incentive to avoid getting fired (avoid shirking)

What is deferred payments?

workers start with low wages and over time the shirking workers are fired and those who remain are paid higher wages in the future

What is paying by performance?

Contract where pay depends on the state of nature.

Practice problem 1: Suppose the principal wants to encourage low effort. The Participation condition is? What is the expected income of the principal is?

U = root of w - 0 >~ 2
Minimum wage needed is 4.

ER=0.7510+0.2570=25 ERNet=25-4=21

Practice problem 1: Suppose the principal wants to encourage high effort. What is the Participation condition. What is the expected income of the principal?

U = root of w − 2 ≥ 2 • In this case minimum wage needed is 16.

ER=0.2510+0.7570=55 ERNet=55-16=39

For practice problem 1 of observable effort what is the result for ERNet? What will the principal choose?

ERNet (low effort)=21 < 38=ERNet (high effort) • Hence principal will want the agent to put in high effort.

ERNet (low effort)=21 < 38=ERNet (high effort) • Hence principal will want the agent to put in high effort. W= 25, when R = 70, W = 1 when R = 10, what is the equation for the ERnet and EU(e=2)?

ERNet=0.25(10-1)+0.75(70-25)=36
EU(e=2)= 0.25( root 1 − 2) + 0.75( root 25 - 2) =2