Moral hazard Flashcards
moral hazard real life explanation
once your phone is insured, you have a lower incentive to take care of it, the insurance company cannot observe this
what is adverse selection
any problem where one party has more information than another about a characteristic or type that is relevant for the transaction
when effort is not observable what can the principal do
principal may need to set a higher wage rate in order to incentivise the agent to exert the higher level of effort
what is moral hazard
Moral hazard occurs when one individual, the agent, takes an action that is not observable by another individual, the principal
what can the asymmetric information take the form of
a characteristic or type as well as where one individual’s actions may not be observable by another party
how does a principal agent model work (moral hazard) *
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
where is the asymmetric information in moral hazard *
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)
what is the principal’s aim in moral hazard
to design the optimal contract that takes into account the fact that the agent will take some action that may be unobserved
how is the firm and worker moral hazard problem a moral hazard problem
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
how is the effort level linked (in moral hazard)
the higher the effort level, the higher the probability of success of the firm
what does the principal do if effort is observable (moral hazard)
if effort is observable, the contract can also stipulate the level of effort e that the agent should exert
what is the agent’s payoff in moral hazard *
u(w) - c(e),
consumption utility - cost of effort,
if rejects contract she gets reservation utility r and exerts no effort
what is separability in moral hazard
the cost of effort does not depend on the wage
what does the agent do if effort is not observable
agent moves second by rejecting or accepting the contract, if the effort is not observed she also chooses her effort level
if effort is not observable how can the principal make the agents give effort
principal can provide the agent with incentives, by adjusting wage rates for the agent to exert a given level of effort
how do you find the subgame perfect nash equilibrium (SPNE) in the moral hazard case *
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)
what do you need to make sure not to do in the full information moral hazard case
don’t count the cost of the effort twice
what is the participation constraint in the moral hazard case
expected utility from working (taking into account either scenario) net of the cost of effort must be greater than their reservation wage
(17)
have a look at 17 front and back lecture notes and just make sure you understand the equations
t
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)
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
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)
because if it did not then the principal could lower the agent’s wage and strictly increase their profit
what is the outcome of the full information moral hazard game where effort is observable *
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
in general for moral hazard when effort is observable how do you find the overall optimal contract finding the optimal level of effort e*
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
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
it is then optimal to offer a fixed wage (for a given level of effort) to the agent
what is the optimal contract when implementing low effort when effort is not observable
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)
what is one difference in the outcome for effort being not observable compared with it being observable under full information
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)
which contract is more efficient for moral hazard the one with information or the effort not observable case
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
if high effort is optimal under full information, moral hazard will cause a ______ _____
welfare loss
from the principal’s point of view in moral hazard the contract will have to achieve a balance between which two goals
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
what does the fact that the principal is assumed to be risk neutral mean about changing the wages of wlow and whigh (MH)
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
for the risk averse agent are they indifferent between increasing the difference between wlow and whigh (MH)
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
