BEE3049 Behavior, Decisions and Markets

BEEM117 Economics of Corporate Finance
Weeks 4,5&6: Asymmetric Information II: Moral Hazard
This topic will introduce students to the concept of moral hazard and its consequence
to contracts. We will cover the basic principal-agent model, whilst determine the
conditions for optimal contracts when effort is unobservable and the impact of the
agent’s risk attitudes to monitoring effort by the principal, the impact of variability of
output and the effect on incentives.
Learning Outcomes:
By the end of this topic you should be able to:
Understand the informativeness principle.
Understand the monitoring-intensity principle.
Understand the incentive-intensity principle.
Understand the ratchet effect
Understand the equal compensation principle
Critically discuss the relevance of moral hazard.
Incorporate the basic principles of contract design in simple stylised problems.
Key concepts:
Moral Hazard, Incentive-Intensity Principle, Monitoring-Intensity Principle, Equal
Compensation Principle, Ratchet Effect.
Milgrom, P. and Roberts, J. Economics, Organisation and Management, Prentice Hall
1992, chapters 6 & 7.
Tirole, J. The Theory of Corporate Finance, Princeton Univ. Press 2006 chapter 3 (pp
113 – 130).
A principal is employing an agent. The agent has expected utility given by
U = E(w) - e²/2D - β²rvar(w). The output z produced by the agent is defined by z = e +
x, where x is normally distributed with mean 0. The agent has a reservation utility
equal to u. The principal pays the agent according to the linear incentive scheme w =
α + βz. The principal’s profits are equal to z – w. The principal is risk neutral and
maximises expected profits.
For given α and β, how much effort will the agent exert?
For a given β, what is the most profitable level of α for the principal?
What are the profit maximising levels of α and β?
Does the agent put in the first best level of effort?
e. How does your answer illustrate the incentive intensity principle?