Moral Hazard: A Brake on DevelopmentLessons from Problem 19.3•Risk-neutral venture capitalists take on all risk and still assure hard work

everyone wins–Risk averse entrepreneurs would be wealthy ($1million for sure)–Lots of ventures would succeed (1 in 10)–Capitalists would have high returns

could finance more ventures

•Recall Marx:Accumulate, accumulate … That is Moses and the Prophets!

Moral Hazard: A Brake on Development• Lessons from Problem 19.3

• But once she’s paid a fixed amount, you know the entrepreneur would rather not work hard– If the venture capitalist is sure she won’t work hard,

he may as well pay her the minimum ($40,000)– The venture now has only a small chance of

success (2%)– While the capitalist still comes out ahead on

average, progress is slowed• Few ventures succeed• Resources to finance new ventures grow

slowly

Moral Hazard: A Brake on Development• Lessons from Problem 19.3

• For better results, capitalist must give the entrepreneur an incentive to work hardThe capitalist’s expected return is diminished from the

best case, in the absence of moral hazard Less resources to finance additional ventures

– Success rate stays the same (1 in 10)– Entrepreneurial incentive may increase

More innovative ideas generated

More ventures proposed Problem of adverse selection

• But entrepreneur may be “squeezed”Will she reinvest her gains: Entrepreneur Capitalist?