Term 1 Lecture 6

Question 1

Problem of a moral hazard

Answer 1

Arises when the agent’s actions affect both parties’ payoffs, but the principal cannot observe them
- agent will act in self-interest, potentially harming the principal’s objectives

Question 2

Necessary conditions for an economic problem to exist

Answer 2

• conflicting objectives
• agent has discretion over their choices
• principal cant directly monitor the Agent’s Actions

Question 3

Difference between adverse selection and moral hazard

Answer 3

Adverse selection - hidden info
- before the transaction, one party has private info the other doesn’t
Moral hazard - hidden actions
- after the transactions, one party takes unobservable actions which affect outcomes

Question 4

Types of incentive schemes

Answer 4

• proportionality, rewards increase linearly with performance
• high-powered incentives, small changes in performance lead to big rewards/ punishments
• relative performance evaluation, performance judged relative to peers
• target and penalty schemes, based on achieving a set goal
• efficiency wages, paying above market wages to reduce shirking.

Question 5

Moral hazard model with workers and managers
- e = 0, means q = 0
- e = 1, means q = 1 with probability k, q = 0 with probability 1-k
- e=1 means cost c>0
- w0 if no output produced, w1 if output produced

Answer 5

1. E = 1, kw1 + (1-k)w0 - c
2. E = 0, w0
3. U
   Managers expected profits:
4. E = 1, k - [ kw1 + (1-k)w0 ]
5. E = 0, -w0

Question 6

Moral hazard model with workers and managers
- e = 0, means q = 0
- e = 1, means q = 1 with probability k, q = 0 with probability 1-k
- e=1 means cost c>0
- w0 if no output produced, w1 if output produced

Constraints in the model:

Answer 6

IR: worker better off working than outside option
Max {kw1 + (1-k)w0 - c, w0} >/ U
IC: worker prefers exerting high effort over low effort
Kw1 + (1-k)w0 - c >/ w0

And vice versa for low effort preferred.

Question 7

Moral hazard model with workers and managers
- e = 0, means q = 0
- e = 1, means q = 1 with probability k, q = 0 with probability 1-k
- e=1 means cost c>0
- w0 if no output produced, w1 if output produced

Managers problem

Answer 7

Suppose manager wanted worker to provide high effort, then she would choose a contract (w0,w1) to solve profit max:

Max: k - (kw1 +(1-k).w0)
Subject to IR and IC.

Question 8

What segment of the IR/IC diagram will the manager choose?

Answer 8

Where they minimise the expected wages, so on the IR curve, while also, while ensuring workers provide high effort, so on or above the IC.