Theme 12 - Asymetric information, Moral Hazard and Contracts

Question 1

What is moral hazard? What can it create?

Answer 1

A situation in which an individual takes a hidden action that benefits him at the expense of another party.

Where this hidden action has consequences for all agents, including those who do not deserve it, moral hazard can create economic distortions.

Question 2

Describe the relation principal-agent. Where does the problem comes from?

Answer 2

Agent: a person who acts (employee)
Principal: party affected by the actions (employer)

The problem comes from the fact that the principal cannot observe the actions of the agent (the effort level), only his performance

Question 3

What happens to the principal when effort is not observable?

Answer 3

The principal is in a situation of asymmetric information

Question 4

What are the 3 types of contracts?

Answer 4

1. Fixed salary: since the agent’s reward does not depend on his actions, he would not exert effort
2. Revenue sharing: incentivize the employee to exert a high level of effort
3. Performance premium: incentivize the employee to exert a high level of effort

Question 5

How can you solve moral hazard problems? Can this solution go wrong?

Answer 5

By providing incentives to the agent to align his interests with those of the principal.

Incentives schemes can go wrong: they can have unintended perverse effects.