ADVANCED MICROECONOMIC

THEORY
 MORAL HAZARD

 Moral Hazard is a problem of hidden action. In a

principal-agent model, the principal cannot monitor
the agent’s actions directly, and so the agent can act
with full discretion.
 In the following model, the principal is a firm and the
agent is worker.
 The worker exerts a level of effort ‘e’, which the firm
can’t directly observe; all it can observe is output ‘z’,
which is the sum of ‘e’ and a stochastic random
variable ‘x’.
 The firm needs to offer a wage that will incentivize the
worker to exert the optimal level of effort.
 MORAL HAZARD

 Variables:  e  Effort Level

 x ' Noise' , E  x   0
 z  Output, z  e  x
 y  Exogenous random variable
correlated with output, y  y x  , E y   0
Observable to all (Oil Shocks)
 C e   Personal cost of employing effort
Convex function
' e' to achieve firm's objective.
 P e   Firm's revenue as a function of effort,
Concave function
If the relationship is random, then it is the
exp ected level of profits.
 MORAL HAZARD
 Wage, expected wage and
variance of wage functions:

 The wage offered by the

employer will be some
 Wage : w  w z , y 
w      z  y 
function of observable
variables, output and the
exogenous random variable.

 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.

 The variance of a constant is Var  w  Var    x  y  

0, and you can break out a

Var  w   2Var  x  y 
parameter from a variance
function by squaring it.
 MORAL HAZARD

 The firm’s expected profits and worker’s utility:

 Worker' s utility  E  w  C  e   12 r 2Var  x  y 

U     e  C  e   12 r 2Var  x  y 
r  risk aversion parameter

 Firm' s expected profits  P e   E  w

E     P e      e 
 MORAL HAZARD
 The first-best scenario for benchmarking:

 As with Adverse Selection, we shall consider the optimal contract when

there is no asymmetric information.

 Var(w)=0 as the firm can observe the worker’s effort directly.

 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).

 Second-Best under Moral Hazard: Risk-Neutral.

 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.

 max U    e  C  e   12 r 2 var x  y 

e

   C ' e SB  INCENTIVE CONSTRAINT

de 1 1
  ; de  d  
d C ' ' e SB   C ' ' e SB  
 The above shows the INCENTIVE CONSTRAINT any incentive feasible contract needs to
fulfil.

 The constraint is that the marginal gain from effort= marginal personal cost of effort.

 Further, we can show how effort reacts to incentives (bottom line).

 MORAL HAZARD

 We know the second best effort, but what about the

optimal parameters? α,β,γ.
 α does not affect overall utility, it just decides how utility
is distributed between the two parties.
 We need to first decide the optimal level of γ, which is
given by the INFORMATIVENESS PRINCIPLE:
 In compensation formulae, total value is always increased
by including a performance measure that reduces the
error with which the agent’s choices are estimated.
 As shown on the next slide, γ only affects profits through
the level of α (as it has no direct effect on effort).
Therefore, we want to select the level of γ that
minimises α.
 MORAL HAZARD
 γ increases with a better covariance between x and y (the
entire point of y is to better gauge ‘x’), and increases with a
smaller variance of ‘y’ (again, makes ‘y’ a better variable to
accurately provide information).

 If the negative sign can be explained:

   e  Ce  12 r 2 var x  y   u
 If ‘y’ is positively correlated with ‘x’, then a high level of
output, ‘z’, is likely to be due to favourable internal market
  u  e  Ce  12 r 2 var x  y 
var x  y   var x   var y   2 cov x, y 
conditions (x), as evidenced by ‘y’. Thus, y is negative:

 min : var x    2 var y   2 cov x, y 

 It decreases pay during good external (+therefore internal)
conditions, and increases pay during bad conditions. Vice
versa for when ‘y’ is negatively correlated with x.

 Applications:
 F .O.C :
2 var y   2 cov x, y   0
 X may be: performance of other workers doing similar tasks, or
other firms in the same industry.

 Y may be the state of the national/regional economy.  cov x, y 


 GEICO (US auto-insurer) bases its compensation of its sales
associates by:
var y 
 It’s percentage growth in policy holders.

 The earnings of it’s seasoned business.

 MORAL HAZARD
 Now we have the optimal value of γ, we can calculate the optimal value
of β.

 To do so, we substitute the incentive constraint into the worker’s utility

function and maximise for the level of effort [let Var(w) = V]:


 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

 P'  e   C '  e   C '  e  rVC ' '  e   0

P'  e
 C '  e   
1  rVC ' '  e 

 This is the INCENTIVE INTENSITY PRINCIPLE.

 MORAL HAZARD

 What influences the optimal intensity of incentives?

 P’(e)  The more profitable incremental effort is, the
greater β.
 r  The lower the risk aversion of the agent, the
greater β (higher β exposes the agent to more risk).
 V  The greater the precision of performance
measurement (lower V), the greater β.
 C’’(e)  The greater the responsiveness of effort to
incentives (C’’(e) is the curvature of C’(e), so a flatter
curve entails a greater responsiveness). A smaller
C’’(e) entails a higher β.
 MORAL HAZARD
•The value of e is
gained where the slope
of C(e) is the same as β.

C(e) •A lower value of C’’(e)

flattens out the curve,
so when β changes ( a
P(e)
change in incentive
intensity), the change
in effort is greater.

•In the first best

scenario C’(e) = P’(e).
•In the second best,
according to the
eSB e* e Incentive intensity
principle, C’(e) < P’(e).
 MORAL HAZARD
 A firm can monitor its employees to reduce ‘V’,
however, this comes at a cost to the firm. What is the
optimal level of monitoring? Let M(V) be the cost of
monitoring to reduce V.
 M ' V   0; M ' ' V   0
 max : E     P  e   E  w  M V 
s.t :   C '  e  ; E  w  C  e   12 r 2V  u
 max : P e   u  C  e   12 r 2V  M V 
V

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

 What if an agent has more than one task to

complete?
 The model is hugely similar to before, but now the
agent has two tasks requiring effort levels e1 and e2.
He regards the tasks as perfect substitutes.
 The principal, as ever, can only observe the output
associated with each of the tasks, not the effort.
 To keep the model simple, we don’t bring in an
external random variable ‘y’, as it wouldn’t change
the conclusion.

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

F .O.C :  The EQUAL COMPENSATION PRINCIPLE:

 e1 : 1  C '  e1  e2 
 If an employee’s allocation of effort between
tasks cannot be monitored, either:

 e2 :  2  C '  e1  e2   The marginal return to the employee

from each activity must be equal, or
 1   2  The activity with the lower marginal return
will be ignored completely.

 This is an extreme case, with perfect

substitutability.
 MORAL HAZARD
 Is it possible to use relative performance evaluation?

 This depends on whether one worker’s output has information on another's.

 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.

 However, if there is a common random variable, say, N: agent one  z1 = e1 + x1 + N, z2 =

e2 + x2 + N.

 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.

 Pay based on absolute performance :

z1  e1  x1  N  var z1   var x1   var N 
 Pay based on relative performance :
z1  z 2  e1  e 2  x1  x 2  var z1   var x1   var x 2 