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THEORY
MORAL HAZARD
Β=Intensity of incentives
(discussed later)
w e x y
γ= weighting given to y. E w E e x y
Recall that the expected
value of both random E w e
variables is 0, and the
Var w Var e x y
expected value of constants
are the constants
themselves.
Var w 2Var x y
parameter from a variance
function by squaring it.
MORAL HAZARD
The result we get is that the optimal level of effort is when the marginal
revenue as a function of effort is = to the marginal cost of exerting
effort.
Assume that the worker has some reservation level of utility ū:
U e C e 12 r 2 0 u
e E w u C e
u C e* If e e*
E P e u C e w
0 If e e*
max : P e u C e
e
P ' e* C ' e *
MORAL HAZARD
Let’s consider two cases of asymmetric information; the first is where the
agent is risk neutral and does not care about the variance of their wage (r=0),
and the second is where the agent is risk averse and dislikes variability (r>0).
If the agent is risk-neutral, then it is rational that the firm will offload all risk
and uncertainty onto the agent while assuring they still get their reservation
utility.
In essence, there is a franchising agreement where the agent runs the firm
and reimburses the firm with an agreed fee ‘k’ afterwards.
The result is that the first-best level of effort (e*) is still obtained!
E w P e K Firm sets U u
max U P e K C e
u P e* K C e *
e
P ' e* C ' e* K P e C e u
* *
MORAL HAZARD
Second-Best under Moral Hazard: Risk-Averse.
The firm won’t operate a franchising agreement as the
agent dislikes extra risk and requires a higher β to be
compensated.
The constraint is that the marginal gain from effort= marginal personal cost of effort.
max : P e E w P e u C e 12 2 rV
e
max : P e u C e 12 C ' e rV
2
e
F .O.C : M ' V 12 r
Monitoring Intensity Principle:
If an agent has higher incentives (β), their
performance will be monitored more closely.
MORAL HAZARD
Cost of effort C e1 e 2
z1 e1 x1 ; z 2 e2 x2
MORAL HAZARD
w 1 z1 2 z 2 1 e1 x1 2 e2 x2
E w 1e1 2 e2 ; var w var 1 x1 2 x2
max : U E w C e1 e2 12 r var w
max : U 1e1 2 e2 C e1 e2 12 r var 1 x1 2 x2
e1 ,e2
e1 : 1 C ' e1 e2
If an employee’s allocation of effort between
tasks cannot be monitored, either:
Consider the situation where agent one’s output is z1 = e1 + x1, and agent two’s is z2 = e2 +
x2.
In this case, there is no common variable, and using agent two’s output as a variable for
agent one’s output just adds noise.
In this case there may be scope for relative performance evaluation, as shown below,
depending on the relative variances of x2 and N.
There is also a link to the Informativeness principle; if both agent’s performance measures
are correlated, then they may confer info about each other’s.