Week 9 MORAL HAZARD Flashcards
What is a principle and what is an agent
Principle who is delegates the task
Agent is who the task is delegated to
What is the model set up with the principal-agent problem?
Principal hires an agent to work on a project on their behalf.
Principal and agent write contract which specifies the compensation to the agent which depends on e and other factors.
Agent’s effort is not observable.
Therefore, the compensation will depend on the outcome of the project.
What are the examples of moral hazard?
Owner / Manager relationship
Owner wants manager to put in effort but the only way this can be observed is through outcome.
Insruance company / someone buying insurance.Person buying insurance knows if they are bad, whilst the insurer finds this hard to observe.
Banks and their borrowers
How to answer a moral hazard question that says:
What kind of contract should the principal offer the agent so that the agent exerts effort?
Find the wages at which the agent exerts effort.
What is the framework of a simple moral hazard problem?
-Principal wants agent to work for him
-The agent can exert high effort or low
ehigh or elow
-If the work was done well revenue will be 6 if the work was done badly it will have 2
-Success of a project depends on effort as well as random factor
-if agent puts in high effort, they get high revenue with p = 1/2
-if agent puts in low effort they get high revenue with 0
-In order for agent to put in high effort they get disutility of 1
-x is the compensation from princiap to agent.
Agents utility is a mix of compensation and effort.
-Then solve to the two constraints
-Then sub these in to get the payoff to agent and principal
In principal agent problems what do we say about risk and what implication does this have?
Principal is risk neutral
Agent is risk averse
Principal has linear payoff function
Agent has concave payoff function
What is the participation constraint in terms of the moral hazard framework
The payoff of exerting effort must be at least greater to the payoff of not exerting any effort.
What is the incentive compatibility constraint in terms of the moral hazard framework
The payoff to putting in effort must be higher than putting low effort.
What is important about the constraints participation and compatibility when holding under equality
ONLY EQUAL UNDER PROFIT MAX
How does the principal create the compensation so it incentivises the agent to put in high effort
- Participation constraint - needs to lead to a higher payoff than putting not working
- Compatbility constraint - needs to lead to a higher payoff than putting in low effort.
Why do the constraints hold with equality under profit max?
Otherwise the principal can keep reducing compensation where the inequality is satisfied.
What does it mean if someone shirks in a problem?
They put in no effort.
What is the second type of model with moral hazard?
Same overall set up but instead of disutility there is a monetary cost.
-Then write out PC
and IC
-Then find xs and xf
