• Now let us move on to another kind of
uncertainty.
Economics 1011a:
Intermediate Microeconomics
Lecture 22: Moral Hazard
Tuesday December 12, 2006
1011a – Lecture 21
Moral Hazard and Insurance
• The idea of moral hazard is that in an
insurance contract, insured people will not
take enough effort to make themselves safe.
• This is because often the insurance
company can only see what ultimately
happens, and cannot monitor what steps you
took to prevent bad outcomes.
1011a – Lecture 21
• We first explored what happens when there
is asymmetric information about types.
• Now we will see what happens when there
is asymmetric information about actions.
This is called moral hazard.
1 1011a – Lecture 21 2
An Insurance Example
• First assume that there is a probability p(e)
that you will have a negative shock z to
your income.
• The cost of effort is ce.
• Hence, without insurance, utility is
p(e )u ( y − z ) + (1 − p(e ))u ( y ) − ce
3 1011a – Lecture 21 4
 Effort Without Insurance Effort With Insurance (I)
• Maximizing this over e yields FOC • If you pay q up front, you get $1 if the
shock occurs.
( )
c = − p ' e* (u ( y ) − u ( y − z ))
• Note that the LHS is the marginal cost of • Let I denote the level of insurance
effort, and the RHS is the marginal benefit. purchased.

• But what happens if insurance is available? • Now you maximize:

max p(e )u ( y − z + (1 − q )I ) + (1 − p(e ))u ( y − qI ) − ce
e ,i

1011a – Lecture 21 5 1011a – Lecture 21 6

Effort With Insurance (II) Full Insurance & No Effort

• Now there are two FOCs: • Substituting in q=p(e*) means the second equation
becomes
( )
c = − p ' e* (u ( y − qI ) − u ( y − z + (1 − q )I )) ( )( ( ))
p e * 1 − p e* (
u ' y − qi * )
=
( )
p e* (1 − q ) (
u ' y − qi * ) ( ( ))( ( ))
1 − p e* p e* (
u ' y − z + (1 − q )i * )
=
( ( )) (
1 − p e* (q ) u ' y − z + (1 − q )i * ) • As we saw before, if the price of insurance is actuarially
fair, people will fully insure themselves: i*=z.
• Let us assume that insurance markets are
• But with full insurance, there is no reason to exert effort to
competitive, so that we end up with q=p(e*). prevent the bad state. So in equilibrium e*=0.
• It’s true that you get full insurance, but p(0) is very high,
• What will happen in equilibrium? and hence you pay a lot for it. Is there a better solution?

1011a – Lecture 21 7 1011a – Lecture 21 8

 Limited Coverage Finding the Optimal Limit
• Let us assume now that there is a limit on the amount of • A social planner knows that, in equilibrium, we will have
coverage that one can buy. Call this limit Imax q=p(e*), and everyone will set I=Imax.

• In the real world, this takes the form of a deductible. • This means that the social planner solves:

max
max
I
( e
( ) ( )
max p(e )u y − z + (1 − q )I max + (1 − p (e ))u y − qI max − ce )
• We know that in equilibrium the price of insurance must
• Hence one must balance the provision of insurance
be fair, so people will buy as much as they can.
against giving the consumer the incentive to behave
responsibly and exert effort.
• But as Imax decreases, effort will increase.
• We will not solve this, but typically one has the optimal
• Hence we can find the Imax that maximizes utility. Imax < z.

1011a – Lecture 21 9 1011a – Lecture 21 10

The Principal-Agent Problem Actions and Luck

• For this to be a problem, it must be that the agent’s
• The other canonical form of moral hazard is the action does not totally determine the final
principal-agent problem. outcome.

• In this situation, a principal hires an agent to do • Otherwise, the principal could easily figure out
something for him (e.g. to produce something). what the agent did.

• However, the principal cannot observe the action • There must also be some (unobservable) thing that
the agent takes (e.g. whether the agents works also influences the outcome.
hard or is lazy).
• For example: even if the agent works hard, he
• He can only observe the final result (e.g. whether might have bad luck and his product breaks
the production was successful). anyways.
1011a – Lecture 21 11 1011a – Lecture 21 12
 The Principal’s Objective Contract Negotiation
• We usually consider this problem from the principal’s
point of view. • The way we model the negotiation over
the worker’s contract is as follows:
• He is trying to get his agent to take the efficient action.

1. The principal makes a take-it-or-leave-it

• However, he wants to do this as cheaply as possible.
offer to the agent.
• But the fact that he cannot observe the agent’s action might
make this difficult.
2. The agent accepts the offer if its expected
• To proceed, we need a way to model contract negotiation.
utility is at least as big as the worker’s
outside option.
1011a – Lecture 21 13 1011a – Lecture 21 14

A Simple Example (I) A Simple Example (II)

• If production is successful, the principal receives y
• Suppose a Principal hires an Agent to produce a by selling it on the market. Otherwise she gets
Widget. nothing. The principal is risk neutral.

• If the Agent works Hard, the Widget will be • The effort cost to the agent of working Hard is e,
successfully produced with probability pH. and of being Lazy is 0.

• If the Agent is Lazy, the Widget will be • Hence the worker’s utility is u(income)-e in the
case of High effort and u(income) in the case of
successfully produced with probability pL.
Low effort.

• Of course we have that pH > pL. • The worker’s outside option gives him utility U.
1011a – Lecture 21 15 1011a – Lecture 21 16
 The 1st Best Unobservable Effort
• Let us assume it is efficient for the Agent to work • Now, let us assume that the Principal cannot
hard, i.e. observe effort.

pH y − e > pL y
• Then fundamentally the moral hazard problem
( pH − p L )y > e reduces to two constraints:
• If effort is observable, what contract will the
Principal offer the Agent? Remember she must 1. The individual rationality constraint induces
match his outside option! the worker to join the firm.
2. The incentive compatibility constraint induces
u ( w1st ) − e = U the worker to work Hard once there.
1011a – Lecture 21 17 1011a – Lecture 21 18

The Structure of Wages Individual Rationality

• Since now the Principal cannot write a contract
based on effort, it must be based on output.
• Think of this as paying the Agent a base wage w,
plus a bonus b if the widget is produced
successfully.
• The bigger the bonus, the better the Agent’s
incentives, but the more risk he faces.
• Assume that the base wage is w and the bonus b.
• What is the Agent’s expected utility if he works
Hard?
p H u (w + b ) + (1 − p H )u (w) − e
• If the principal wants the agent to work hard, this
needs to be as big as U:
p H u (w + b ) + (1 − p H )u (w) − e ≥ U

1011a – Lecture 21 19 1011a – Lecture 21 20

 Incentive Compatibility The Optimal Contract (I)
• Now we need to make sure that the bonus is big • Formally, the principal solves the problem:
enough to make the Agent work hard.
max pH ( y − b ) − w
• The Agent’s expected utility to working Hard is: w ,b

p H u (w + b ) + (1 − p H )u (w) − e s.t. pH u (w + b ) + (1 − pH )u (w) − e ≥ U (IR)

• The Agent’s expected utility to being Lazy is: s.t. ( pH − pL )(u ( w + b) − u ( w) ) ≥ e (IC)
p L u (w + b ) + (1 − p L )u (w)
• It turns out that to maximize the Principal’s
• So we need: expected profits, she should make them both
p H u (w + b ) + (1 − p H )u (w) − e ≥ p L u (w + b ) + (1 − p L )u (w) hold with equality. Why?

( pH − p L )(u (w + b ) − u (w)) ≥ e • So we can find the optimal wages now.

1011a – Lecture 21 21 1011a – Lecture 21 22

The Base Wage The Bonus

• Rewriting the IR constraint: • Rewriting the IC constraint:
u (w) + p H (u (w + b ) − u (w)) − e = U e
u (w + b ) − u (w) =
• Substituting the IC into the IR yields: pH − pL
e
u (w ) + p H −e =U
pH − pL • So the bonus must be big when:
ep L – The cost of effort is high
u (w ) = U + – Effort and output are not well correlated (i.e.
pH − pL
pH - pL is small)
• So the base wage just moves with the outside – The Agent is very risk averse (why?)
option.
1011a – Lecture 21 23 1011a – Lecture 21 24
 Risk Aversion in the P-A Model
e
u (w + b ) − u (w) =
pH − pL
• The more risk averse the Agent, the less likely the
Principal will want to give him big enough incentives to
actually work hard.

• Note that if the Agent is risk neutral, we have

Expected ( pH − p L )b = e < ( p H − p L ) y Expected
marginal cost to marginal benefit
High effort to High effort

• The principal will set b = y, and w < 0, in effect selling

the firm to the agent.

1011a – Lecture 21 25