Moral Hazard Problem

What is the private information of the agent about?: Unobservable (hidden) actions

When is it relevant?: Post-transaction

What are the strategies to solve the problem?: Principal uses Incentive schemes to provide the agent

with incentives to choose an action that the principal wants them to choose

Examples:

Workers may choose to shirk rather than put in high effort (Note that this may be the case regardless

of the characteristic of the worker as “hardworking” etc. So the hidden characteristics which were

relevant for the adverse selection problems prior to the transaction are no longer relevant)

People may take more risks with insured vehicles if they believe that insurance companies will cover

the cost.
 Example: Moral Hazard in the Labor Market
We studied the adverse selection problem regarding employment—selecting high skilled job
candidates—but once employed, the worker can choose to shirk even if they are high skilled à
moral hazard problem (The employer cannot fully observe the worker’s action.)

SETUP:
• The employer moves first and decides on the kinds of incentives to offer to the workers.

• After seeing the incentive scheme, the worker chooses whether to put in high level of effort eH or
low level of effort, eL.

• The worker’s effort level leads to a probability distribution over possible values of the firm’s profit
level: good (g), medium (m), bad (b)
• even though the profit level depends on the worker’s action, there is no one-to-one relation
due to exogenous uncertainty (upon observing a profit level g, the employer is not sure
whether the worker chose high or low effort.)
 Example: Moral Hazard in the Labor Market
•Worker’s payoff (utility) function: u(w)=2√w

•Cost (disutility) of effort: dH=10, dL=0.

•For simplicity, assume that highest net payoff to the worker from their alternative options is 0.

•Profit levels: g=200, m=100, b=50

•Probability distributions over profit levels:

for eH: P(g)=0.6, P(m)=0.3, P(b)=0.1

for eL: P(g)=0.1, P(m)=0.3, P(b)=0.6

Backward induction reasoning:

Q: What should be the incentive scheme offered by the employer in order for choosing eH to be a best
response for the worker?

Q: Is it a best response for the employer to induce high level of effort, eH, from the worker by offering this
incentive scheme?
The benchmark case: Assume complete information (no moral hazard)
What if the employer could observe the effort level of the worker?
à Pay a “good wage”, wage+bonus, wg, when the worker chooses high effort and
a lower base wage, wb, when the worker chooses low effort.
The employer’s net expected profits:
•if the worker chooses eH:
(0.6xg)+(0.3xm)+(0.1xb)-wg
•if the worker chooses eL:
(0.1xg)+(0.3xm)+(0.6xb)-wb
The employer will want to induce high effort iff:
0.5x(g-b) ≥ wg – wb à wg – wb ≤ 75
benefit to the employer cost to the employer of
from inducing high effort inducing high effort
(the increase in expected
profits if the worker
chooses eH)
 The benchmark case cont’d

Q: What should be the wage+bonus, wg, and the base wage, wb, for choosing eH
to be a best response for the worker?
We need: u(wg) – dH ≥ u(wb) – dL
NOTE: The employer will set wb=0. Why?
Plugging in the numbers and using wb=0, we get:
(2√wg – 10) ≥ 0 à wg ≥ 25
vThe worker will choose eH for wg≥25.
Q: Is it a best response for the employer to induce high level of effort from the
worker by offering these levels of wage+bonus, wg, and the base wage, wb?
vThe employer would try to induce eH if wg≤75, so it is a best-response for the
employer to pay up to 75.
vIn equilibrium, the employer will offer wg=25 and the worker will choose eH.
 Moral Hazard in the Labor Market
Q: What is the optimal incentive scheme from the perspective of the employer? What
about the worker?

ØIn case of moral hazard, the worker’s compensation in an incentive scheme can only
depend on the observed profit level.

ØDifferent incentive schemes will imply different risk sharing between the employer and
the worker. (Risk arises in this case due to the uncertain nature of the profit level.)

We will consider three incentive mechanisms:

1. Pure wage

2. Pure franchise

3. Wage+bonus
 1. Pure wage scheme
The worker receives a fixed wage regardless of the profit level:
wg=wm=wb=w
The employer bears all the risk.
Worker’s payoff:
if chooses eH: u(w) – dH
if chooses eL: u(w) – dL
àThe worker will choose eL.
àThe employer will offer w=0.
Worker’s payoff=0.
Employer’s expected payoff = (0.1xg)+(0.3xm)+(0.6xb)-w = 80.
 2. Pure franchise scheme
The worker pays a fixed sum of money—the franchise fee (f)—to the
employer regardless of the profit level.
The worker bears all the risk.
Employer’s payoff = f
Worker’s expected payoff:
if chooses eH:
[0.6xu(g-f)] + [0.3xu(m-f)] + [0.1xu(b-f)] – dH
if chooses eL:
[0.1xu(g-f)] + [0.3xu(m-f)] + [0.6xu(b-f)] – dL
àThe worker will choose eH iff:
0.5x[u(g-f)-u(b-f)] ≥ dH – dL
à [√(200-f)] - [√(50-f)] ≥ 10
 Pure franchise cont’d

Q: What is the highest franchise fee that the employer can charge?
We need √(50-f) ≥ 0, since otherwise the payoff function of the worker
would not be well-defined (square-root not defined for (-) values).
So, f=50 is the highest fee that the employer can charge.
For f=50: [√(200-f)]-[√(50-f)] ≥ 10
√150 ≥ 10
àThe worker chooses eH, with an expected payoff of 8.9 =
(0.6(2√(200-50))+0.3(2√(100-50))-10)
àThe employer’s payoff is f=50.
 3. Wage + Bonus scheme
The worker is given a base wage (wb) regardless of the profits, and he receives a bonus
only if g or m is observed (bonus will either be wg-wb or wm-wb depending on the realized
profit level).
The risks are shared btw the employer and the worker.
Worker’s expected payoff:
if chooses eH:
[0.6xu(wg)]+[0.3xu(wm)]+[0.1xu(wb)] – dH
if chooses eL:
[0.1xu(wg)]+[0.3xu(wm)]+[0.6xu(wb)] – dL
The worker will choose eH iff:
0.5x[u(wg)-u(wb)] ≥ dH-dL à wg≥100
Recall: wb=0 since dL=0 and the fallback (alternative) payoff is 0.
 Wage + Bonus cont’d
Employer’s expected payoff:
if the worker chooses eH:
[0.6x(g – wg)]+[0.3x(m – wm)]+[0.1x(b – wb)]
if the worker chooses eL:
[0.1x(g – wg)]+[0.3x(m – wm)]+[0.6x(b – wb)]
The employer will be willing to pay the bonus iff:
0.5x(g – b) ≥ 0.5x( wg – wb) à wg – wb ≤ 150

If the worker If the worker chooses eH,

chooses eH, there is there is 50% greater
50% greater chance chance that the employer
that profits will be g. will have to pay the
bonus
Wage + Bonus cont’d

Combining the worker’s and the employer’s

conditions:
worker… wg≥100
wg=100
employer … wg≤150

Worker’s payoff=2
Employer’s payoff=95
 To sum up…
Employer’s Worker’s
Effort level in Who bears
expected expected
equilibrium the risk?
payoff payoff

No moral hazard high 130 0 Employer

Pure wage
low 80 0 Employer

Moral Pure
franchise high 50 8.9 Worker
hazard
Wage +
Bonus high 95 2 Shared
Q: The phrase "scientia potentia est" (or "scientia est potentia" or
also "scientia potestas est") is a Latin aphorism meaning
"knowledge is power.”

Is this true for adverse selection problems?

What about moral hazard problems?

Ask: WHO BEARS THE COST OF INFORMATION ASYMMETRY?