Moral hazard

Question 1

moral hazard real life explanation

Answer 1

once your phone is insured, you have a lower incentive to take care of it, the insurance company cannot observe this

Question 2

what is adverse selection

Answer 2

any problem where one party has more information than another about a characteristic or type that is relevant for the transaction

Question 3

when effort is not observable what can the principal do

Answer 3

principal may need to set a higher wage rate in order to incentivise the agent to exert the higher level of effort

Question 4

what is moral hazard

Answer 4

Moral hazard occurs when one individual, the agent, takes an action that is not observable by another individual, the principal

Question 5

what can the asymmetric information take the form of

Answer 5

a characteristic or type as well as where one individual’s actions may not be observable by another party

Question 6

how does a principal agent model work (moral hazard) *

Answer 6

principal offers a take it or leave it contract to the agent,
agent accepts or rejects offer, if accepts she takes some action which may be unobserved by the principal,
outcome, to be shared according to the terms of the contract, depends in part on the agent’s action

Question 7

where is the asymmetric information in moral hazard *

Answer 7

after the principal makes the take it or leave it offer the agent takes some action which may be unobserved by the principal,
(outcome to be shared according to terms of the contract depends in part on the agent’s action)

Question 8

what is the principal’s aim in moral hazard

Answer 8

to design the optimal contract that takes into account the fact that the agent will take some action that may be unobserved

Question 9

how is the firm and worker moral hazard problem a moral hazard problem

Answer 9

because firm makes initial offering,
then the worker decides what effort to exert and this affects the outcome for both but effort is not observable to the firm

Question 10

how is the effort level linked (in moral hazard)

Answer 10

the higher the effort level, the higher the probability of success of the firm

Question 11

what does the principal do if effort is observable (moral hazard)

Answer 11

if effort is observable, the contract can also stipulate the level of effort e that the agent should exert

Question 12

what is the agent’s payoff in moral hazard *

Answer 12

u(w) - c(e),
consumption utility - cost of effort,
if rejects contract she gets reservation utility r and exerts no effort

Question 13

what is separability in moral hazard

Answer 13

the cost of effort does not depend on the wage

Question 14

what does the agent do if effort is not observable

Answer 14

agent moves second by rejecting or accepting the contract, if the effort is not observed she also chooses her effort level

Question 15

if effort is not observable how can the principal make the agents give effort

Answer 15

principal can provide the agent with incentives, by adjusting wage rates for the agent to exert a given level of effort

Question 16

how do you find the subgame perfect nash equilibrium (SPNE) in the moral hazard case *

Answer 16

use backward induction,
agent will only accept wage (after taking off cost of effort and taking into account the two possible outcomes) if it is greater than the reservation wage,
then principal will want to maximise their expected return conditional on the agent accepting the contract,
do lagrangian and find optimal wage,
(participation constraint)
(17)

Question 17

what do you need to make sure not to do in the full information moral hazard case

Answer 17

don’t count the cost of the effort twice

Question 18

what is the participation constraint in the moral hazard case

Answer 18

expected utility from working (taking into account either scenario) net of the cost of effort must be greater than their reservation wage
(17)

Question 19

have a look at 17 front and back lecture notes and just make sure you understand the equations

Answer 19

t

Question 20

does the participation constraint bind at the optimum for the moral hazard full information case (PC=workers utility from working must be higher than reservation wage)

Answer 20

it always binds at the optimum, as if it did not then the principal could lower the agent’s wage and strictly increase their profit

Question 21

why does the participation constraint bind at the optimum in moral hazard full information (PC=workers utility from working must be higher than reservation wage)

Answer 21

because if it did not then the principal could lower the agent’s wage and strictly increase their profit

Question 22

what is the outcome of the full information moral hazard game where effort is observable *

Answer 22

after finding the lagrangian (back 17) and deriving the first order conditions,
find that w_= w above line so the wage rates do not depend on success or failure, this represents full insurance for the agent, since they no longer face any risk,
then find the optimal wage rate by using the binding participation constraint

Question 23

in general for moral hazard when effort is observable how do you find the overall optimal contract finding the optimal level of effort e*

Answer 23

to find overall optimal contract, need to find optimal high-effort contract as well as the optimal low-effort contract and compare the firm’s payoff from each

Question 24

when effort is observed by the risk-neutral principal in moral hazard what is it optimal for them to offer to the risk-averse agent

Answer 24

it is then optimal to offer a fixed wage (for a given level of effort) to the agent

Question 25

what is the optimal contract when implementing low effort when effort is not observable

Answer 25

contract wlow=whigh, this contract is also the optimal contract for implementing low effort when effort is not observable, it satisfies IC, and we know it maximises the principal’s objective function subject to PC (which is binding)

Question 26

what is one difference in the outcome for effort being not observable compared with it being observable under full information

Answer 26

the expected wage payment will be higher in the not observable case (in order to stay at reservation utility level, the agent needs to be compensated by the principal for bearing some of the risk)

Question 27

which contract is more efficient for moral hazard the one with information or the effort not observable case

Answer 27

overall for not observable the agent is still at reservation utility (no better off than before) but the principal is worse off due to the extra wage cost, hence this contract is less efficient than the high-effort contract under full information

Question 28

if high effort is optimal under full information, moral hazard will cause a ______ _____

Answer 28

welfare loss

Question 29

from the principal’s point of view in moral hazard the contract will have to achieve a balance between which two goals

Answer 29

efficiency in production (incentivising agent to exert effort level that maximises production),
risk allocation (more risk allocated to agent, more she will need to be compensated in terms of expected wage),
when effort observable only latter concern is relevant

Question 30

what does the fact that the principal is assumed to be risk neutral mean about changing the wages of wlow and whigh (MH)

Answer 30

if wlow is decreased by an amount and whigh is increased by the same amount, since the principal only cares about the expected wage cost, she is indifferent to this change in wage rates

Question 31

for the risk averse agent are they indifferent between increasing the difference between wlow and whigh (MH)

Answer 31

increasing the difference between whigh and wlow, while holding expected wage constant, increases uncertainty and, therefore makes her worse off, principal therefore needs to compensate agent for extra risk by increasing expected wage which is costly to principal