ECON S Copyright Hidden Information, Moral Hazard & Performance Incentives Lecture 4

ECON S Copyright 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’

ECON S Copyright Moral Hazard Examples Individual action that is inefficient for the organization –Personal business –Stealing –Maximizing bonus activities (Result from an inability to monitor activities)

ECON S Copyright 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

ECON S Copyright 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?

ECON S Copyright 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

ECON S Copyright 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)