Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management Chapter 6: Moral Hazard and Performance Incentives Examples of Moral Hazard: When those with critical information have interests different from those of the decision maker, they may fail to report completely and accurately the information needed to make good decisions. When buyers cannot easily monitor the quality of the goods or services that they receive, there is a tendency for some suppliers to substitute poor quality goods or to exercise too little effort, care or diligence in providing the services.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management Moral hazard is the form of post-contractual opportunism that arises because actions that have efficiency consequences are not freely observable and so the person taking them may choose to pursue his or her private interests at others’ expense. The term moral hazard originated in the insurance industry, where it referred to the tendency of people with insurance to change their behavior in a way that leads to larger claims against the insurance company. For example, being insured may make people lax about taking precautions to avoid or minimize losses.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management The Principal-Agent Relationship. The term principal- agent has come to be used in organizational economics to refer to situations in which one individual (the agent) acts on behalf of another (the principal) and is supposed to advance the principal’s goals. The moral hazard problem arises when agent and principal have differing individual objectives and the principal cannot easily determine whether the agent’s reports and actions are being taken in pursuit of the principal’s goals or are self- interested misbehavior.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management The Principal-Agent Relationship. Agency Relationships are pervasive: The doctor is the agent to the patient; The worker is the agent of the firm; and The CEO is the agent of the owners.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management An important instance of moral hazard arises in employment relationships, where employees may shirk their responsibilities. Evidence of the importance of moral hazard in the employment relationship is the frequency with which firms give employees compensation to various measures of performance, and are meant to motivate effort, creativity, care, diligence and so on.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management Berle and Means (1932) argued that the dispersed holdings of stocks across a multitude of small investors had created an effective separation of ownership and control, with no individual stockholder having any real incentive to monitor managers and ensure that the officers and board were running the firm in the owners’ interests. The problem typically is not that the executives are lazy and do not work hard enough. Corporate executives work remarkably long hours of very intense effort. Rather, the complaint is that they pursue goals other than maximizing the long-run value of the firm. Critics claim that executives invest firms’ earnings in low- value projects to expand their empires when the funds would be better distributed to the shareholders to invest for themselves.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management In order for a moral hazard problem to arise, three conditions must hold: There must be some potential divergence of interests between people; There must be some basis for gainful exchange or other cooperation between the individuals; and There must be difficulties in determining whether in fact the terms of the agreement have been followed and in enforcing the contract terms. These difficulties often arise because monitoring actions or verifying reported information is costly or impossible,

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management The first remedy for moral hazard problems is to increase the resources devoted to monitoring and verification. The second remedy for moral hazard problems is that managers who do a poor job in competitive product and input markets will face greater probability of unemployment, and reduced reputation. The third remedy is the “market for corporate control” (I.e., takeovers). A fourth remedy is explicit incentive contracts that balance the costs of risk-bearing against the benefits of improved performance. A fifth remedy is an economic bond (collateral) to ensure performance.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management The efficiency of the size of the firm is limited, in part, by influence activities. Influence activities arise in organizations when organizational decisions affect the distribution of wealth or other benefits among members or constituent groups of the organization and, in pursuit of their selfish interests, the affected individuals or groups attempt to influence the decision to their benefit. The costs of these influence activities are influence costs.

Milgrom and Roberts (1992): Chapter 6 Economics, Organization & Management When two previously separate organizations are brought under a common central management with the power to intervene, the scope for influence costs increase. For example, members of one unit can try to influence top management to transfer resources from the other unit to their unit. Large amounts of time, ingenuity, and effort may go into these attempts at influence, and huge amounts of the central executives’ time can be consumed dealing with these influence activities.