Week 1 Moral Hazard

Question 1

What is Moral Hazard and give a car insurance example. Give a way car insurances reduce this.

Answer 1

When one party has incentive to perform risky behaviour.
When applying or car insurance there is asymmetric information, the applicant knows more about themselves than the insurer. When insurance obtained, applicant may feel like able to take risk, after all they have insurance.
1. Cheaper car insurance for long term no claim bonus

Question 2

Principal Agent Relationship, give the three key aspects

Answer 2

Asymmetric information, Risk preferences, Difference in interest

Question 3

Principal Agent Relationship: Give the three theories A…C…I..

Give four Solutions

Answer 3

Agency - aims to solve issues based on interest and risk tolerance
Contract - aims to solve issues of asymmetric information through contracts
Information - explores how decisions are affected based on information

Performance based incentives, Regular checks, screening processes and strict contracts

Question 4

There are effort based contracts and output based contracts, explain the difference

Answer 4

Effort based can be on milestones or hours worked and incentivises the worker to expect reward based on hard work. Alternatively, the output based contract has a clear target and only incentivises the worker to reach that goal and nothing more this can be good for the employer who can manage costs easier.

Question 5

Economic Theory: Explain broadway game and its meaning

Answer 5

Assume a broadway show is being created. The principal is the producer the agent is the investor. The principal wants to put in a great show the agent wants to get a return on his profit. The moral hazard here is the effort the principal (producer) puts in. High effort, better results, etc.
If success there could be more shows for producer, agent gets more more money etc
If fail then boiling in water essentially means the consequences will be dire, terrible reputation, no shows etc

The meaning of the theory is the dynamic of the principal and agent depends on a multitude of factors and having a good system for the principal to work but also severe drawbacks if failure increase the chances of overall success.

Question 6

Explain a forcing contract and tell me the equation

Answer 6

A forcing contract is where the employer pays a wage when employee performs exactly at optimal effort and receives no pay if not optimal effort.

w(e)=w w(e) =/ w when e =/ e =/ w
=/ means not equal

Question 7

Explain thresehold contract and give me the equation

Answer 7

Employers pay wage when effort is at least or above the desired effort e*.

w(e equal to or above e)=w
w(e less than e*)=/w

No pay if below e* but pay if e* or above however pay does not increase so incentivised to just do e*

Question 8

Linear contract, explain and provide equation

Answer 8

Employers pay wage according to the function. w(e) = alpha + betaE

employee chooses alpha + betaE= w because at E* that is max wage and thus max utility

Question 9

There are three main contract types: Explain them all without giving the equation and give a reason as to why employers would do that`

Answer 9

Forcing contract is when wage is only paid when effort is optimal and nothing more or less, this is great to keep costs and ensure correct effort however is prone to stress and employees may find it constantly demanding

Thresehold contract allows workers to work at optimal effort or above however gets no pay for working below optimal effort - this gives room for over acheivers however optmial utility still lies at optimal effort

Linear contract pays wage on a function - allows for a range of effort and different wages which can be useful to identify those who are not performing at optimal effort but also reduces pressure