Moral Hazard

The moral hazard problem involves

decision making with hidden action

In a moral hazard problem, one individual

may take certain actions which affect the
value of a transaction to another individual

However, the second individual cannot

(perfectly) monitor/enforce the actions of
the first individual
there is asymmetric information

Classic examples include fire/car insurance

Solutions to the moral hazard problem

involve using incentives
the second individual may structure the
transaction so that the first individual
finds it optimal to undertake the action
desired by the second individual

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Principal-Agent Problem
There are two individuals : a manager who
is the principal and a worker who is the
agent

The principal wants the worker to work as

hard as possible. However, the manager
cannot observe the action of the worker

The problem for the manager is to design a

payment scheme to induce the worker to
work hard. The agent can choose between
two actions a, b

If the agent chooses action b, the principal

receives profit
xb sxb
while the agent receives utility
sxb c b

2
Full Information
The principal (a monopolist) has full
information about the agents costs, actions
and output levels

the principals objective is to decide which

action he wants the agent to take and design
an incentive scheme to induce that action

Suppose the principal wants the agent to

take action b
max xb sxb
b,s.

such that
sxb c b u

sxb c b sxa c a
(1) is the participation constraint, (2) is
the incentive compatibility constraint

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Solution
Irrelevant whether the solution is based on
output or action as both observed

Example : Target Output Scheme

If the target is met, the agent receives
an amount equal to reservation utility
If the target is not met, the agent is
punished harshly

However, the solution is sensitive to

information imperfections such as noise
It may not work with hidden action

4
Hidden Action
Suppose that the actions of the agent cannot
be observed directly but the output cann be
observed

Output, however, is random : high output

may be due to high effort but it may also be
due to good luck
ia is the probability that x i is
produced when action a is chosen

If action b is chosen, the principal wants to

maxx 1 s 1 1b x 2 s 2 2b
b,s i

such that
us 1 1b us 2 2b c b u 1

us 1 1b us 2 2b c b
us 1 1a us 2 2a c a 2

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Possible Solutions
If actions are hidden, the payment can only
be based on output levels

Since output is random, payments are

random
if can base payment on action, can
achieve first best solution even when
output is random

Target output scheme : agent paid only if

target output is met which implies
Expected utility may be less than
reservation utility and the agent may
not participate

Fixed payment : the agent is paid a given

amount regardless of output
if the agent bears no risk, the agent
does not care about the outcome
there is no incentive to chose the
desired action

6
Graphical Solution
Technically, it is easier to solve this
problem if the objective function is
non-linear, constraints are linear

The objective function is the expected

profits of the firm, the constraints are the
incentive compatability constraint and the
participation constraint

We will assume that if a worker produces

x 1 , he gets paid u 1 while producing x 2
means that the worker will get paid u 2

Hence, the firm is now choosing utility

levels rather than actual payments s 1 , s 2

We will also assume that there is a cost to

the firm of providing these utility levels
(payments) and this alteration will show up
in expected profits

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The Incentive Compatability
Constraint

Given the above, the incentive

compatability constraint becomes
u 1 1b u 2 2b c b
u 1 1a u 2 2a c a

Solving as an equality and rearranging, we

can write

u 2 u 1 c2bb ca
2a

This has a slope of 1 and an intercept

given by the second term

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 The participation constraint is one of the
b indifference curves
u 1 1b u 2 2b c b u

Rearranging, we can now write

u 2 u 2bc b u1 2b1b

This has a slope of 1b / 2b with an

intercept given by the first term

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Isoprofit Lines
Graphically, the firm will want to pick the
lowest isoprofit line subject to the two
constraints
an isoprofit line gives combinations of
payments u 1 , u 2 which yield the same
level of profits

Changing the problem slightly, we will

assume that the isoprofit function of the
firm is concave to the origin

Notice that the isoprofit lines are decreasing

in u 1 , u 2

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Results

If the incentive compatibility constraint is

not binding c a c b , the optimal incentive
contract involves paying the agent a
constant amount such that u 1 u 2
the optimal incentive contract is such
that the agent bears no risk

If the incentive compatibility constraint is

binding (c b c a ), the optimal incentive
contract involves paying the agent such that
u2 u1
the optimal incentive contract is such
that the agent will bear some risk

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