Moral Hazard and Performance Incentives

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Moral Hazard and Performance Incentives
Incentives are the essence of economics ---
Edward P. Lazear
Chapter 6
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The Concept of Moral Hazard
Moral Hazard is a form of post-contractual
opportunism that arises because actions that have
efficiency consequences are not freely observable
so the person taking them may choose to pursue
his or her private interests at the expense of
others
This arises when individuals or organizations do
not bear the full cost of their actions
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Efficiency Effects of Moral Hazard
Moral Hazard is an information problem that
occurs between a principle and an agent
Incomplete contacting results from the inability
or cost associated with monitoring
appropriate/desired behavior
In essence insurance lowers the cost of
something and more is consumed than dictated by
efficiency
Examples???
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Savings and Loans A numerical Example
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(No Transcript)
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This is a case of playing with other peoples
money
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A Sampling of U.S. Government Insurance and
Guarantee Programs
Pension Benefit Guaranty Program
Ginny Mae, Fanny Mae and Freddie Mac?
Social Security?
Medicare and Medicaid?
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Moral Hazard in Organizations
Moral hazard can be used to explain many aspects
of organizational structure. Type of moral
hazard problems include
Employee shirking
Managerial Misbehavior - separation of ownership
and control
Financial Contracts debt versus equity financing
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Controlling Moral Hazard
For a moral hazard problem to arise three
conditions must hold
There must be some real or potential divergence
of interests between relevant parties
There must be some basis for gainful exchange
that activates these divergent interests
There must be difficulties in determining whether
the terms of the agreement have been followed and
in enforcing the contract
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Controlling Moral Hazard
Monitoring
Explicit Incentive Contracts
Bonding
Others???
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Organizational Structure and Moral Hazard An
Example