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M ORAL H AZARD

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.

M ORAL H AZARD

Variables:

Convex function

Concave function

y e ! Effort Level y x !' Noise' , Ex ! 0 y z ! Output, z ! e x y y ! Exogenous random variable correlated with output, y ! yx , Ey ! 0 Observable to all (Oil Shocks) y Ce ! Personal cost of employing effort ' e' to achieve firm' s objective. y Pe ! Firm' s revenue as a function of effort, If the relationship is random, then it is the exp ected level of profits.

M ORAL H AZARD

age, expected wage and variance of wage functions: The wage offered by the employer will be some function of observable variables, output and the exogenous random variable. =Intensity of incentives (discussed later) = weighting given to y. Recall that the expected value of both random variables is 0, and the expected value of constants are the constants themselves. The variance of a constant is 0, and you can break out a parameter from a variance function by squaring it.

**y Wage : w ! wz , y
w ! E F z Ky
w ! E F e x Ky
E y E w
! E ? F e x Ky
A E w
! E Fe E y Var w
! Var ? F e x Ky
A Var w
! Var ?F x Ky
A
**

Var w
! F 2Var ?x Ky A

M ORAL H AZARD

The firm s expected profits and worker s utility:

U ! E F e C e 1 rF 2Var ?x Ky A 2 r ! r k aver Fir E T Pe E parameter Fe

y Worker s tility ! E w C e 1 rF 2Var ?x Ky A 2

xpected pr fit

Pe E w

M ORAL H AZARD

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 u:

y U ! E F e C e
1 rF 2 0 ! u 2 E F e ! E w
! u C e

y y

P ' e* ! ' e*

T ! Pe u e ax : Pe u e e

® C * If e ! e* e ± w!¯ ± 0 If e { e* °

M ORAL H AZARD

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!

y E
! Pe
K U ! _ e
K a P y

e

y i m sets U !

e

P ' e* ! ' e*

e
K ! P
e e

* * *

e ! P * K

M ORAL H AZARD

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 to be compensated.

y ma U ! _ F ea C e
1 rF 2 var?x Ky A E 2

e

y F ! C ' e SB

INCENTIVE CONSTRAINT

1 de 1 ; de ! dF y ! SB dF C ' ' e 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).

M ORAL H AZARD

We know the second best effort, but what about the optimal parameters? , , . 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 , 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, only affects profits through the level of (as it has no direct effect on effort). Therefore, we want to select the level of that minimises .

M ORAL H AZARD

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: If y is positively correlated with x , then a high level of output, z , is likely to be due to favourable internal market conditions (x), as evidenced by y . Thus, y is negative: It decreases pay during good external (+therefore internal) conditions, and increases pay during bad conditions. ice versa for when y is negatively correlated with x. Applications: 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. GEICO (US auto-insurer) bases its compensation of its sales associates by:

y E Fe Ce 1 rF 2 va ?x Ky A! u 2 E ! u Fe Ce 1 rF 2 va ?x Ky A 2

va ?x Ky A! va ?x A va ? y A 2 cov?x, Ky A K

It s percentage growth in policy holders. The earnings of it s seasoned business.

y min va ?x A K 2 va ?y A 2K cov?x, y A

K

y F .O.C 2K va ?y A 2 cov?x, y A! 0 cov?x, y A K! va ?y A

M ORAL H AZARD

Now we have the optimal value of , we can calculate the optimal value of . 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]:

y ax : P e

e e

! Pe _ e u

r

a

e
? ' e
A r P ' e
' e
' e
r ' ' e
! P ' e
y ' e
! ! r ' ' e

ax : Pe
u

This is the INCENTIVE INTENSITY PRINCIPLE.

M ORAL H AZARD

What influences the optimal intensity of incentives? P (e) The more profitable incremental effort is, the greater . r The lower the risk aversion of the agent, the greater (higher exposes the agent to more risk). V The greater the precision of performance measurement (lower V), the greater . 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 .

M ORAL H AZARD

The value of e is gained where the slope of C(e) is the same as . C(e) P(e) A lower value of C (e) flattens out the curve, so when changes ( a 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 Incentive intensity principle, C (e) < P (e).

eSB

e*

e

M ORAL H AZARD

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.

y M '
0; M ' '
" 0 V V y ax E T
! P e
E w
M
V ; s.t F ! C ' e
E w
C e
1 rF 2V u u 2 y ax Pe
u C e
1 rF 2V M
V 2

V

F .O.C M ' ! 1 rF V 2

Monitoring Intensity Principle:

If an agent has higher incentives ( ), their performance will be monitored more closely.

M ORAL H AZARD

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 ! Ce1 e 2 z1 ! e1 x1 ; z 2 ! e2 x2

M ORAL H AZARD

y w ! E F1 z1 F 2 z 2 ! E F1_ 1 x1a F 2 _ 2 x2 a e e

E w
! E F1e1 F 2 e2 ; va w
! va ?F1 x1 F 2 x2 A max U ! E w
C e1 e2
1 r va ?wA 2

y max U ! E F1e1 F 2e2 C e1 e2
1 r va ?F1 x1 F 2 x2 A 2

e1 , e2

F . .C

y e2 F 2 ! C ' e1 e2
@ F1 ! F 2 y e1 F1 ! C ' e1 e2

The EQUAL COMPENSATION PRINCIPLE: If an employee s allocation of effort between tasks cannot be monitored, either:

The marginal return to the employee from each activity must be equal, or The activity with the lower marginal return will be ignored completely.

This is an extreme case, with perfect substitutability.

M ORAL H AZARD

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.

y Pay based on absolute performance : z1 ! e1 1 N var?z1 A! var? 1 A var?N A y Pay based on relative performance : z1 z 2 ! e1 e 2 1 2 var? 1 A! var?

1

A var? 2 A

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