(9) Moral Hazards and Inventive Contracts

Question 1

Participation Constraint - Definition

Answer 1

• Agent will only accept participation constraint if incentive > opportunity costs
• Difference between PC when ICC is binding and non-binding

Question 2

Incentive Compatibility Constraint - Definition

Answer 2

• Align the incentives of the agent so that they become compatible with the principal’s goal

Question 3

Piece Rate - Definition

Answer 3

• Wage the worker receives

- Depends on the output level

Question 4

Full Information Case

Answer 4

• Effort level can be observed

Question 5

Partial Information Case

Answer 5

• Effort level cannot be observed but we can relate pay to the success of the firm
• Wage becomes risky (if ICC is binding there has to be a risk premium)
• Loss of efficiency due to information asymmetry (risk premium increases costs)

Question 6

Moral Hazard - Definition

Answer 6

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.