Lecture 21: Moral Hazard I

What are components of human capital?

Education, on-the-job training, experience, and innate ability.

What is the “motherhood penalty”

Reduced earnings and job advancement due to motherhood-related preferences, norms, or institutional factors.

Do managers matter

Yes. Management consulting improved plant productivity by 17% and led to expansion.

What’s the principal-agent problem?

Misaligned incentives between someone making a decision (agent) and someone affected by the outcome (principal).

• pay depends on outcome

Why do incentives sometimes fail?

Outcomes are observable, but effort is hidden; agents act in their own interest.

What’s the goal of designing incentives?

Align agents’ decisions with the organization’s goals.

Plan 1: Worker gets paid only if road is high quality.

Creates incentive to exert high effort if expected payoff is greater than low-effort payoff.

Plan 2: Worker gets fixed salary.

Worker will exert low effort if effort is costly and not rewarded directly.

Why might a principal prefer a fixed salary

If effort-based pay requires high costs or the risk of losing the worker due to a better outside offer.

What are downsides of strong incentives?

• Risk for agent

• Costly to the firm

• May crowd out intrinsic motivation

• May lead to unethical behavior or gaming the system

What’s moral hazard?

When agents take unobservable actions that may not align with the principal's interests, especially after a contract is signed.

What’s the issue with multitasking and incentives?

Focusing incentives on one task can reduce effort in others, especially if tasks are substitutes.

What’s the difference between complement and substitute efforts?

Complements: Doing one helps the other (e.g. research & teaching)

Substitutes: Doing one drains energy from the other (e.g. teaching vs grading).

What’s effort substitution?

When agents shift effort toward the incentivized task, potentially neglecting others.

intrinsic motivation

• purpose and growth

feels good , learn , develop skills

extrinsic motivation

• money security and praise

pay/compensation , benefits, rewards

adverse selection

wrong person for the job

moral hazard

isnt making any effort : dosent try hard

principle payoff =

task payoff- pay of laborer

agents payoff

pay of labor - cost of effor