Adverse Selection or Moral Hazard Rick’s Iron Skillet on South School changed formats and now offers a lunch buffet. The management has noticed that the average consumption of customers has increased.

Adverse Selection or Moral Hazard An 8 year old acquires a credit card, runs up large bills online and refuses to pay.

Adverse Selection or Moral Hazard The IMF helps bail out countries that experience financial crises.

Adverse Selection or Moral Hazard Wal-Mart has noticed that employees who stay employed longer tend to be in poorer health and thus have higher health care costs.

Contracting When we can’t perfectly monitor what someone does, we want compensation and choices to be connected. e.g. selling the worker the right to the output. (franchising)

Risk Concerns Expected Output = 6e 1/2 +  where  is a random component. What will happen to selling price if worker is risk averse? no random component – selling price was $193

Optimal Risk Sharing Most individuals are risk averse –for given income level, prefer less dispersion in outcomes Shareholders have diverse portfolios –less concerned about performance of any one company Employees receive substantial income from single company

Contracts and Risk Contracts provide incentive and share risk Wage = B 0 +B 1 Output B 0 +B 1 (6e 1/2 +  Selling rights to output essentially had B 0 =-193 and B 1 =18 (the market price).

Contracts and Risk (Risk Neutral) Worker’s Problem: Maximize payoff = B 0 +B 1 (6e 1/2 +  e 2  B 0 +B 1 6e 1/2 + B 1  e 2 d  /de= (1/2)B 1 6e -1/2  e 2 =0 which does not depend on B 0 So changing flat component will not impact effort, but changing incentive component will.

Other Forms of Incentives Bonus for exceeding thresholds Gold Stars and other prizes Firing for bad performance Others??

Evaluating Individual Performance Setting Benchmarks (Relative v Absolute) Time and Motion Studies Past Performance Perverse Incentives the Ratchet Effect – if targets adjust based on this period’s performance, then employees do not want to set the bar to high.

Evaluating Individual Performance Perverse Incentives gaming – teaching to the test - giving discounts to customers to delay orders - not helping coworkers - sitting on a research paper - peer pressure not to blow the curve horizon - typically trades long run for short run.

Subjective Performance Evaluation Multiple tasks and unbalanced effort Subjective evaluation methods –Standard rating scales –Goal-based systems Problems –Supervisor shirking –Forced distribution –Influence costs –Reneging

Performance Optimal evaluation is some combination of objective and subjective components. (Depends on marginal cost and marginal benefit of specific situation)