Lecture 23: Moral Hazard II

incentivising complements

if efforts are compliments then incentrivicing one activity will also improve performance on the other dimension

incentivising substitutes

if efforts are substitues then incentivizing one activity decreases the bonus on other project

• need to equally incentives

What’s the classic insight from “On the Folly of Rewarding A While Hoping for B”

: Incentives must be aligned with desired outcomes; otherwise, you encourage the wrong behaviors.

How can incentives lead to unethical behavior?

People respond to what’s rewarded, even if it conflicts with organizational goals

What are examples of misconduct in organizations?

Unnecessary medical procedures, employee theft, slacking on critical tasks.

What factors contribute to misconduct?

• Differences in preferences

• Moral hazard

• Poor self-selection

• Overconfidence

• Social influence from peers

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What are pros and cons of strong culture?

✅ Motivation, innovation, satisfaction
❌ Rigidity, resistance to change, potential for unethical behavior

What is delegation in a firm?

Assigning decision-making to someone else.

What is the Information Principle?

Delegate to someone with the relevant knowledge.

give power to those with relavent information

What is the Ally Principle?

Delegate to someone who shares your goals/incentives.

• give decision power to someone with similar objectives

Why is delegation tricky?

You often have to trade off between knowledge and aligned incentives.

What is monitoring?

Oversight/supervision to reduce unwanted behavior after delegation or hiring.

Police-Patrol:

• Centralized and proactive (e.g., audits, classroom checks)

Fire-Alarm

• Reactive, relies on complaints or reports (e.g., 911, whistleblowers)

What are the benefits of Fire-Alarm monitoring?

• Focus on real violations

• Cheaper for the organization (costs shift to public/complainants)

What is the problem of collusion in monitoring?

gents (e.g., lawyers, teachers) may avoid complaints by pandering or even bribing, undermining accountability.

How can firms respond to collusion?

1. Random investigations

2. Reducing alarm stakes

3. Rotating agents to avoid entrenched interests

What did Pierce et al. (2015) find about IT-based monitoring

• Theft dropped 22%

• Revenue increased 7%

• Monitoring boosted honest workers’ motivation

What is the multitask problem?

Incentivizing one task may hurt performance in another, especially when tasks are substitutes.