Applied Microeconomics

1
Applied Microeconomics

• Asymmetric Information II

2
Outline

• Moral Hazard
• Incentive Contracts

3
Readings

• Kreps Chapter 19
• Perloff Chapter 20

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Moral Hazard

• 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.

5
Examples
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Principal-Agent

• Often expressed as a principal-agent relationship
• A principal is any person or firm that hires
  another another person or firm to perform
  services
• An agent is any person or form hired to perform
  service for a principal

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When Does Moral Hazard Occur?

• Principal and agent have divergent interests
• Agent is insured against some of the consequences
  of his actions
• Monitoring and enforcement of contract between
  agent and principal is imperfect

8
Example 1 Private Life Insurance in the U.S.

• Most private life insurance pays off on the
  policy only if a suicide occurs a certain period
  of time after the policy was issued
• This exclusion period is usually 12 or 24 months
• Life insurance statistics show that suicide rates
  are lowest in the 12th and the 24th and highest
  in the 13th and 25th month after a policy has
  been issued

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Example 2 Savings Loans Crisis in the 1980s

• SLs borrowed money from the public and then
  invested it
• If they could not repay depositors, a federal
  government agency did
• SL shifted from relatively safe investments to
  junk bonds
• 500 SLs went bankrupt causing tax payers losses
  of hundreds of billions of dollars

10
Example 3 Agricultural Workers in the
Philippines

• Foster and Rosenzweig (1994) came up with the
  idea of estimating the effort of farm workers by
  measuring their body mass (weight/squared height)
  loss
• They found that agricultural workers in the
  Philippines who work for themselves use up
  between 10-13 more body mass than workers who
  work for others

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Remedies

• Intrinsic motivators such as pride
• Norms of appropriate behavior
• Reputation
• Risk of getting fired
• Promotion
• Financial incentives

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Application

• A risk-neutral principal wants to hire a
  risk-averse agent with utility function
  u(w,e)w0.5-(e-1) and reservation utility 1
• The agent can choose between effort levels e1
  and e2
• If e1, the principals revenue is 9 with prob.
  2/3 and 30 with prob. 1/3, giving an expected
  revenue of 16
• If e2, the principals revenue is 9 with prob.
  1/3 and 30 with prob. 2/3, giving an expected
  revenue of 23

13
Observable and Verifiable Effort

• Remember that optimal risk-sharing implies that
  the risk-neutral principal should bear all of the
  risk
• To elicit high effort e2, the principal would
  have to pay the agent at least w224 for this
  effort, giving the principal an expected profit
  of 23-419
• To elicit low effort, the principal would have to
  pay the agent at least w1 for e1, giving the
  principal an expected profit of 16-115
• Hence, the principal is strictly better off
  eliciting the high effort

14
Unobservable or Unverifiable Effort

• If effort is not observable and the firm offers a
  fixed wage w, due to moral hazard, the agent will
  always exert effort e1
• Anticipating this, the principal will set the
  wage w1, resulting in an expected profit of
  16-115
• If effort is not observable, it is no longer
  optimal for the risk-neutral principal to bear
  all risk by offering a fixed wage

15
Unobservable or Unverifiable Effort

• What about making the agent a franchise holder
  and charging him a fee equal to his gross profits
  (just like in the case of double
  marginalization)?
• This would work fine if the agent were risk
  neutral, but not with a risk-averse agent
• There is a trade-off between efficient
  risk-sharing and motivation

16
Explicit Incentive Contracts

• Suppose the principal offers the agent an
  incentive contract that pays the agent y when
  revenues are 9 and z when they are 30
• In order to elicit effort e2, the principal
  solves maxx,y0 23-y/3-2z/3 subject to (I)
  y0.5/32z0.5 /3-11 (IR)(II) y0.5/32z0.5/3-12y0
  .5/3z0.5/3 (IC)

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Explicit Incentive Contracts

• Rewrite (IR) z0.5 3-y0.5/2
• Rewrite (IC) z0.5 3y0.5
• If we plot these inequalities in a diagram, we
  can solve for the optimal contract

18
Explicit Incentive Contracts
19
Explicit Incentive Contracts

• The solution is z9 and x0, paying 9 when
  revenues are high and 0 otherwise
• This gives the principal an expected profit of
  23-92/317
• This is better than the profit with fixed wages
  (15) and worse than the profit with observable
  effort (19)
• The agents payoff is the same the higher
  expected wage merely serves to compensate her for
  the higher risk

20
Explicit Incentive Contracts

• In general, the optimal variable component of the
  wage depends on
• The profitability of incremental effort ()
• The precision with which the desired activities
  are assessed ()
• The agents risk aversion (-)
• The agents responsiveness to incentives ()

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Other Determinants

• Multitask Jobs
• Group Incentives
• Tournaments
• Dynamic effects

22
Multitask Jobs

• If the agent has several tasks and effort is
  unobservable, they should all have the same
  compensation
• Suppose the principal values both output and
  quality of work if one gives a higher
  compensation, the agent will focus all his
  attention on this task
• Example Teachers
• Solution may be not to use incentive contracts

23
Group Incentives

• Sometimes incentives are tied to group
  performance
• Problem Free riding
• Benefits
• Hard to measure individual contributions
• Promotes cooperation
• Small groups are good at self-monitoring

24
Rank Tournaments

• If several agents output is affected by some
  common random component, then the optimal
  contract often involves some comparison of
  individuals
• Problems
• Different skill levels
• Unhealthy competition
• Incentives for collusion
• Large rewards required with large group
• Solution may be to compare performance with
  external group benchmarking

25
Dynamic Effects

• Some incentive contracts base performance on
  previously achieved outcomes
• The ratchet effect
• No incentives to perform better than target
• Incentives to hold back in order to make next
  year easier
• Incentives to change job after a good year

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What Motivates Citibank Employees?
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Conclusion

• Moral hazard occurs when a principal and an agent
  has different interests, the agents effort is
  not perfectly observable, and the agent does not
  bear the full consequences of his activities
• One solution is incentive contracts that balance
  motivation and risk-sharing
• Other solutions are based on intrinsic
  motivation, reputation, etc