Moral hazard and contracts 1

Introduction Review Moral hazard The principal-agent problem Adverse Selection Signals Seperating equilibrium « Unobserved types » Moral hazard « Unobserved actions » The principal-agent problem Incentives and contracts

Moral hazard (and risk) Ex: You just bought theft insurance for your home. Do you install an alarm system? The tendency to be less careful when risks are eliminated is an example of moral hazard. Because insurance changes the costs of misfortune, and because people's choices depend on costs and benefits, insurance should change people's behavior. They should make less effort to avoid misfortune, and this change in behavior is called moral hazard.

Moral hazard (and management) When a manager has a secure position from which he or she cannot be readily removed. When a manager is protected by someone higher in the corporate structure. When funding and/or managerial status for a project is independent of the project's success. When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division. When there is no clear means of determining who is accountable for a given project.

Moral hazard (and finance) Bailout by the government creates a risk for moral hazard. Credit card users... CEO’s objectives vs. Shareholders ...

The principal-agent problem If your employer pays you a fixed monthly salary, are you motivated to work hard? Agent: person who acts (employee) Principal: party affected by the actions (employer) The problem comes from the fact that the principal cannot observe the effort level of the agent, only his performance.

Unfavorable context (50%) Example You are managing an employee in a watch factory. He can provide a level of effort which is low (e = 0) or high (e = 1). Both of you are risk-neutral. Uncertainty about demand. Firm’s revenue: Unfavorable context (50%) Favorable context (50%) Low effort (e = 0) R = 10 000 $ R = 20 000 $ High effort (e = 1) R = 40 000 $ Working hard costs him the equivalent of 10,000$.

If effort is observable If w(e=0) is your employee’s base salary, how must you choose w(e=1) to motivate him to work hard? Is it profitable for you?

If effort is observable If w(e=0) is your employee’s base salary, how must you choose w(e=1) to motivate him to work hard? w1 at least 10,000$ Is it profitable for you? ER(e=0)=0.5*10K$+0.5*20K$= 15K$ ER(e=1)=0.5*20K$+0.5*40K$-10K$ = 20K$

If only revenue is observable If you pay your employee a fixed salary (w(R) ≡ constant), which level of effort will he choose?

If only revenue is observable If you pay your employee a fixed salary (w(R) ≡ constant), which level of effort will he choose? On a constant salary, because effort is costly, his dominant strategy is to exert no effort because it only reduces his net benefit. (Moral hazard!)

Performance premium If you offer the following payment scheme: w(R) = $1,000 if R = $10,000 or $20,000 w(R) = $24,000 if R = $40,000 Which effort level will your employee choose? What will your (expected) profit be?

Performance premium Expected utility (net benefit): w(R) = 1 000 $ if R = 10 000 $ or 20 000 $ w(R) = 24 000 $ if R = 40 000 $ Unfavorable cntxt.(50%) Favorable cntxt. (50%) Low effort (e = 0) EU(R) = 1000 $ High effort (e = 1) EU(R) = 1K$-10K$ = -9K$ EU(R) = 24K$ -10K$ = 14K$ Because the agent is risk-neutral, he picks the effort level that maximizes his expected net-beneft. EU(e=1)=(14000-9000)/2=2500$ > EU(e=0)=1000$

Performance premium Expected Profits: R-W(R) Unfavorable cntxt.(50%) Favorable cntxt. (50%) Low effort (e = 0) 10K$-1K$=9K$ 20K$-1K$=19K$ High effort (e = 1) 40K$-24K$=16K$ π(e=0) = 50%*9K$ + 50%*19K$=14K$ π(e=1) = 50%*19K$ + 50%*16K$=17.5K$ We can expect profits of 17,500$ because the agent should exert a high effort.

Revenue sharing If you use the following payment schedule w(R) = R – $18,000 if R > $18,000 w(R) = $1,000 otherwise What will your employee’s expected net benefit be if he exerts low effort? What will his net benefit be if he exerts high effort? What will he choose? What will your expected(?) profit be?

Revenue sharing If you use the following payment schedule: w(R) = R – 18 000 $ if R > 18 000 $ w(R) = 1 000 $ otherwise Unfavorable cntxt.(50%) Favorable cntxt. (50%) Low effort (e = 0) EU(R) = 1000 $ EU(R) = 2000 $ High effort (e = 1) EU(R) = 2K$-10K$ = -8K$ EU(R) = 22K$-10K$ =12K$ Here too, high effort is the worker’s dominant strategy. EU(e=1)=2K$ > EU(e=0)=1.5K$

Revenue sharing Expected profits: R-W(R) Unfavorable cntxt.(50%) Favorable cntxt. (50%) Low effort (e = 0) 10K$-1K$=9K$ 20K$-2K$=18K$ High effort (e = 1) 40K$-22K$=18K$ π(e=0) = 50%*9K$ + 50%*18K$=13.5K$ π(e=1) = 50%*18K$ + 50%*18K$=18K$ We can expect profits of 18,000$ if the agent exerts a high effort.

Conclusions Our environment has an impact on our behavior  incentives matter! Next: final exam 

Exercise 10 As Chairman of the Board of ASP Industries you estimate that your firm’s annual profit is given by the table below. Profit () is conditional upon market demand and the effort of your new CEO. The probabilities of each demand condition occurring are also shown in the table. Market Demand Low Demand Medium Demand High Demand Market Probabilities .30 .40 Low Effort =$5 million =$10 million =$15 million High Effort =$17 million

Exercise 10 You must design a compensation package for the CEO that will maximize the firm’s expected profit. While the firm is risk neutral, the CEO is risk averse. The CEO’s utility function is: Utility = W½ when making low effort Utility = W½ -100, when making high effort, where W is the CEO’s income. (The -100 is the “utility cost” to the CEO of making a high effort.) You know the CEO’s utility function, and both you and the CEO know all of the information in the preceding table. You do not know the level of the CEO’s effort at time of compensation or the exact state of demand. You do see the firm’s profit, however.

Exercise 10 Of the three alternative compensation packages below, which do you as Chairman of ASP Industries prefer and why? PACKAGE 1: Pay the CEO a flat salary of $575,000 per year. PACKAGE 2: Pay the CEO a fixed 6 percent of yearly firm profits. PACKAGE 3: Pay the CEO a flat salary of $500,000 per year and then 50 percent of any firm profits above $15 million.

Exercise 11 A firm’s short-run revenue is given by: R = 10e – e² where e is the level of effort by a typical worker (all workers are assumed to be identical). A worker chooses his level of effort to maximize his wage net of effort (the per-unit cost of effort is assumed to be 1). U = w - e

Exercise 11 Determine the level of effort and the level of profit (revenue less wage paid) for each of the following wage arrangements. Explain why these differing principal-agent relationships generate different outcomes. w = 2 for e  1; otherwise w = 0. w = R/2 w = R - 12.5