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Hidden Information, Moral Hazard & Performance Incentives

Lecture 4

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Moral Hazard

• “Post contractual opportunism”• Available when actions required or expected by a

‘contract’ cannot be observed• A party taking advantage of circumstances to benefit from

a ‘contract’ beyond the expectations when the contract was made

• Insurance example: After insurance contract is made – the insured engages in behavior that increases the risk of the insurance company beyond the expectations at the time it made the contract - ‘Adverse Selection’

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Moral Hazard Examples

• Individual action that is inefficient for the organization– Personal business– Stealing– Maximizing bonus activities

(Result from an inability to monitor activities)

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Moral Hazard

• Suppliers/customers tempted to take inefficient action where they have different interests and monitoring is ineffective– Poor quality, mistakes, etc.

• Demutualization of Insurance Companies

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Moral Hazard – Employee Shirking

• Is incentive compensation the answer? – Compelling theory v. inefficient implementation

• What you want is employee inputs & what you incent is employee outputs

• Managerial misbehavior – Can it be avoided? Are expost actions ever efficient? Corporate takeovers as examples?

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Moral Hazard & Financial Structures

• Equity holders benefit disproportionately from successful risk!

• Debt holders??

• US bankruptcy law may incent moral hazard – Reduces penalty for ‘Corporate Failure’

• Too Big to Fail as Moral Hazard! • Excuse or reality of 2008 financial crisis

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Controlling Moral Hazard

• Monitoring requires information that is useful and timely (complete v. incomplete)

• Explicit incentive contracts – Information about the future is uncertain! Risks?

• Bonding – Put up something of value: i.e. retirement entitlements (Enforcement might shift burden to society)