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Moral Hazard
MICROECONOMICS
Principles and Analysis
Frank Cowell
Almost essential
Risk
Prerequisites
June 2004
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The moral hazard problem
A key aspect of hidden information
Information relates to actions.
Hidden action by one party affects probability of
favourable/unfavourable outcomes.
Hidden information about personal characteristics is
dealt with...
... under adverse selection.
... under signalling.
However similar issues arise in setting up the
economic problem.
Set-up based on model of trade under uncertainty.
Jump to
Adverse
selection
Jump to
Signalling
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Overview...
The basics
A simplified
model
The general
model
Moral Hazard
Information:
hidden-actions
model
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Key concepts
Contract:
An agreement to provide specified service
in exchange for specified payment
Type of contract will depend on information available.
Wage schedule:
Set-up involving a menu of contracts
The Principal draws up the menu
Allows selection by the Agent
Again the type of wage schedule will depend on information
available
Events:
Assume that events consist of single states-of-the-world
Distribution of these is common knowledge
But distribution may be conditional on the Agents effort
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Strategic foundation
A version of a Bayesian game.
Two main players
Alf is the Agent.
Bill is the Boss (the Principal)
An additional player
Nature is player 0
Chooses a state of the world
Bill does not observe what this is...
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Principal-and-Agent: extensive-
form game
0
[RED] [BLUE]
1t

t

Bill Bill
Alf
[NO]
[OFFER]
[high]
[NO] [OFFER]
Alf
[low] [high] [low]
"Nature" chooses a state of the world
Probabilities are common knowledge
Principal may offer a contract, not
knowing the type
Agent chooses whether to accept
contract
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Extension of trading model
Start with trading model under uncertainty
There are two states-of-the world
So exactly two possible events
Probabilities of the two events are common knowledge
Assume:
A single physical good
so consumption in each state-of-the world is a distinct
contingent good.
Two traders Alf, Bill
CE in Edgeworth box determined as usual:
Draw a common tangent through the endowment point.
Gives equilibrium prices and allocation
But what happens in noncompetitive world?
Suppose Bill can completely exploit Alf
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Trade: t common knowledge
O
a

O
b

x
RED

a

x
RED

b

x
BLUE

b

x
BLUE

a

Certainty line for Alf
Alf's indifference curves
Certainty line for Bill
Bill's indifference curves

Endowment point
CE prices +allocation
t
RED

____
t
BLUE


t
RED

____
t
BLUE

Alf's reservation utility

If Bill can exploit Alf...
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Outcomes of trading model
CE solution as usual potentially yields gains to
both parties
Exploitative solution puts Alf on reservation
indifference curve
Under CE or full-exploitation there is risk sharing
Exact share depends on risk aversion of the two parties.
What would happen if Bill, say, were risk neutral?
Retain assumption that t is common knowledge
We just need to alter the b-indifference curves
The special
case
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Trade: Bill is risk neutral
O
a

O
b

x
RED

a

x
RED

b

x
BLUE

b

x
BLUE

a

Certainty line for Alf
Alf's indifference curves
Certainty line for Bill
Bill's indifference curves

Endowment point
CE prices +allocation
t
RED

____
t
BLUE


Alf's reservation utility

If Bill can exploit Alf...
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Outcomes of trading model (2)
Minor modification yields clear-cut results
Risk-neutral Bill bears all the risk
So Alf is on his certainty line
Also if Bill has discriminatory monopoly power
Bill provides Alf with full insurance
But gets all the gains from trade for himself
This forms the basis for the elementary model of
moral hazad.
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Overview...
The basics
A simplified
model
The general
model
Moral Hazard
Lessons from the
2x2 case
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Outline of the problem
Bill employs Alf to do a job of work
The outcome to Bill (the product) depends on
A chance element
The effort put in by Alf
Alf's effort affects probability of chance element.
High effort high probability of favourable outcome
Low effort low probability of favourable outcome
The issues are:
Does Bill find it worth while to pay Alf for high effort?
Is it possible to monitor whether high effort is provided?
If not, how can Bill best construct the contract?
Deal with the problem in stages
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Simple version the approach
Start with simple case
Two unknown events
Two levels of effort
Build on the trading model
Principal and Agent are the two traders
But Principal (Bill) has all the power
Agent (Alf) has the option of accepting/rejecting the
contract offered.
Then move on to general model
Continuum of unknown events.
Agent has general choice of effort level
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Power: Principal and Agent
Because Bill has power:
Can set the terms of the contract
...constrained by the Alfs option to refuse
Can drive Alf down to reservation utility
If the effort supplied is observable:
Contract can be conditioned on effort: w(z)
Get all the insights from the trading model
Otherwise:
Have to condition on output: w(q)
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The 22 case: basics
A single good
Amount of output q is a random variable
Two possible outcomes
Failure q

_
Success q
Probability of success is common knowledge:
given by t(z)
z is the effort supplied by the agent
The Agent chooses either
Low effort z
_
High effort z
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The 22 case: motivation
The Agent's utility derives from
consumption of the single good x
a
(|)
the effort put in, z (+)
Given vNM preferences utility is Eu
a
(x
a
, z) .
The Agent is risk averse
u
a
(, ) is strictly concave in its first argument
The Principal consumes all output not consumed
by Agent
x
b
= q x
a

(In the simple model) Principal is risk neutral
Utility is Eq x
a

Can interpret this in the trading diagram
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Low effort
O
a

O
b

x
RED

a

x
RED

b

x
BLUE

b

x
BLUE

a

t
RED

____
t
BLUE

O
b

Certainty line for Alf (Agent)
Alf's indifference curves
Certainty line for Bill
Bill's indifference curves
Endowment point
Alf's reservation utility
If Bill exploits Alf
then outcome is on
reservation IC, u
a

If Bill is risk-
neutral and Alf risk
averse then
outcome is on Alf's
certainty line.
u
a

Switch to high
effort
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High effort
O
a

O
b

x
RED

a

x
RED

b

x
BLUE

b

x
BLUE

a

O
b
O
b

Certainty line and indifference
curves for Alf
Certainty line and indifference
curves for Bill
Endowment point
Alf's reservation utility
t
RED

____
t
BLUE

High effort tilts
the ICs, shifts
the equilibrium
outcome.
Contrast with
low effort
Combine to get
menu of
contracts
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Full information: max problem
The Agent's consumption is determined by the wage paid.
The Principal chooses a wage schedule...
w = w(z)
...subject to the participation constraint:
Eu
a
(w,z) > u
a
.
So, problem is choose w() to maximise
Eq w + [Eu
a
(w,z) u
a
]
Equivalently
_
Find w(z) that maximise t(z) q + [1 t(z)] q w(z)...
_
... for the two cases z = z and z = z.
Choose the one that gives higher expected payoff to Principal
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Full-information contracts
O
a

O
b

x
RED

a

x
RED

b

x
BLUE

b

x
BLUE

a


w(z)
q


w(z)

w(z)

w(z)

q
Alf's low-effort ICs
Alf's high-effort ICs
Bills ICs
Bills ICs
Low-effort contract
High-effort contract
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Full-information contracts: summary
Schedule of contracts for high and low effort
Effort is verifiable
Contract specifies payment in each state-of-the-world
State-of-the-world is costlessly and accurately observable
Equivalent to effort being costlessly and accurately observable
Alf (agent) is forced on to reservation utility level
Efficient risk allocation
Bill is risk neutral
Alf is risk averse
Bill bears all the risk
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Second best: principles
Utility functions
As before
Wage schedule
Because effort is unobservable
...cannot condition wage on effort or on the state-of-the-world.
But resulting output is observable...
... so you can condition wage on output
Participation constraint
Essentially as before
(but we'll have another look)
New incentive-compatibility constraint
Cannot observe effort
Agent must get the utility level attainable under low effort
Maths
formulation
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Participation constraint
The Principal can condition the wage on the observed
output:
_ _
Pay wage w if output is q
Pay wage w if output is q
Agent will choose high or low effort.
This determines the probability of getting high output
...and so the probability of getting a high wage.
Let's assume he would choose high effort
(check this out in next slide)
To ensure that Agent doesn't reject the contract...
...must get the utility available elsewhere:
_ _ _ _ _
t(z) u
a
(w, z) + [1 t(z)] u
a
(w, z) > u
a

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Incentive-compatibility constraint
Assume that the Agent will actually participate
_ _
Pay wage w if output is q
Pay wage w if output is q
Agent will choose high or low effort.
To ensure that high effort is chosen, set wages so the
following holds:
_ _ _ _ _
t(z) u
a
(w, z) + [1 t(z)] u
a
(w, z) >
_ _
t(z) u
a
(w, z) + [1 t(z)] u
a
(w, z)
This condition determines a set of w-pairs
a set of contingent consumptions for Alf
must not reward Alf too highly if failure is observed
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Second-best contracts
O
a

O
b

w


w
x
RED

a

x
RED

b

x
BLUE

b

x
BLUE

a

Alf's low-effort ICs
Bills ICs
Alf's high-effort ICs
Bills ICs
Full-information contracts
Participation constraint
Incentive-compatibility
constraint
u
a

Second-best contract
Bills second-best
feasible set
Contract
maximises Bills
utility over
second-best
feasible set
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Simplified model: summary
Participation constraint
Set of contingent consumptions giving Alf his reservation utility.
If effort is observable get one such constraint for each effort level
Incentive compatibility constraint
Relevant for second-best policy.
Set of contingent consumptions such that Alf prefers to provide
high effort.
Implemented by making wage payment contingent on output
Intersection of these two sets gives feasible set for Bill
Outcome depends on information regime
Observable effort: Bill bears all the risk
Moral hazard: Alf bears some risk
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Overview...
The basics
A simplified
model
The general
model
Moral Hazard
Extending the
first-order
approach

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General model: introduction
Retain assumption that it is a two-person contest.
Same roles for Principal and Agent. But
Allow for greater range of choice for Agent
Allow for different preferences for Principal
Again deal with full-information case first.
Draw on lessons from 22 case
Same principles apply
Then introduce the possibility of unobserved
effort.
Needs some modification from 22 case
But similar principles emerge
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Model components: output and
effort
Production depends on effort z and state of the
world e:
q = |(z,e)
e e O
Effort can be anything from zero to full
z e [0,1]
Output has a known frequency distribution
f(q, z)
Support is the interval [q, q]
Increasing effort biases distribution rightward
Define proportional effect of effort |
z
:= f
z
(q, z)/f(q, z)

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Effect of effort
f(q, z)
q
q

q

Support of the distribution
Output distribution: low
effort
Output distribution: high
effort
Higher effort
biases frequency
distribution to
the right
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Model components: preferences
Again the Agent's utility derives from
the wage paid, w (|)
the effort put in, z (+)
Eu
a
(w, z) .
u
a
(, ) is strictly concave in its first argument
The Principal consumes output after wage is paid
But we allow for non-neutral risk preference
Eu
b
(x
b
) = Eu
b
(q w)
u
b
() is concave

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Full information: optimisation
Alfs participation constraint:
Eu
a
(w,z) > u
a
.
Bill sets the wage schedule.
Can be conditioned on the realisation of e
w = w(e)
To set up the maximand, also use
Bills utility function u
b

production function |
Problem is then
choose w()
to max Eu
b
(|(z,e))
subject to Eu
a
(w(e),z) > u
a
.
Lagrangean is
Eu
b
(|(z,e) w(e)) + [Eu
a
(w(e), z) u
a
]

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Optimisation: outcomes
The Lagrangean is
Eu
b
(x
b
) + [Eu
a
(x
a
,z) u
a
]
where x
a
= w(e) ; x
b
= |(z,e) w(e)
Each w(e) and z can be treated as control variables
Bill chooses w(e) .
Alf chooses z, knowing the wage schedule set by Bill.
First-order conditions are
u
x
b
(|(z,e) w(e)) + u
x
a
(w(e),z) = 0
Eu
x
b
(|(z,e) w(e))|
z
(z,e) + Eu
z
a
(w(e), z) = 0
Combining we get
u
x
b
(x
b
) / u
x
a
(x
a
) =

| u
z
a
(x
a
, z) |
Eu
x
b
(x
b
)|
z
(z,e) + E u
x
b
(x
b
) = 0
\ u
x
a
(x
a
, z) .
x
b
= |(z,e) w(e)
x
a
= w(e)
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Full information: results
Result 1
u
x
b
(x
b
) / u
x
a
(x
a
) =
Because u
x
a
and u
x
b
are positive must be positive.
So participation constraint is binding
Ratio of MUs is the same () in all states of nature
Result 2
| u
z
a
(x
a
, z) |
Eu
x
b
(x
b
)|
z
(z,e) + E u
x
b
(x
b
) = 0
\ u
x
a
(x
a
, z) .
In each state Bills (the Principals) MU is used as a weight.
In the special case where Bill is risk-neutral...
...this weight is the same in all states. Then we have:
| u
z
a
(x
a
, z) |
E |
z
(z,e) = E
\ u
x
a
(x
a
, z) .

Expected MRT = Expected MRS for the Agent
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Full information: lessons
Principal fully exploits Agent
Because Principal drives Agent down to reservation utility
Follows from assumption that Principal has all the power
(No bargaining)
Efficient risk allocation
Take MRS between consumption in state-of-the-worlds e and e'
MRS
a
= MRS
b

Efficient allocation of effort
In the case where Principal is risk neutral...
Expected MRTS
zx
= Expected MRS
zx
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Second-best: introduction
Now consider the case where effort z is unobserved
This is equivalent to assuming state-of-the-world e
unobserved
Can work with the distribution of output q:
Transformation of variables from e to q
Just use the production function q= |(z,e)
Clearly effort shifts the distribution of output
Use the expectation operator E over the distribution of output.
All model components can be expressed in terms of this
distribution
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Second-best: components
Objective function of Principal and of Agent are as before.
Distribution of output f depends on effort z.
Probability density at output q is f(q, z)
Participation constraint for Agent still the same
Modify it to allow for redefined distribution
Require also the incentive-compatibility constraint
Builds on the (hidden) optimisation of effort by the Agent
Again use Lagrangean technique
Assumes problem is well-behaved
This may not always be appropriate
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Second-best: problem
Bill sets the wage schedule.
Cannot be conditioned on the realisation of e
But can be conditioned on observable output
w = w(q)
Bill knows that Alf must get at least reservation utility :
Eu
a
(w(q),z) > u
a
.
participation constraint
Also knows that Alf will choose z to maximise own utility
So Bill assumes (correctly) that the following FOC holds:
E(u
a
(w, z)|
z
) + Eu
z
a
(w, z) = 0
This is the incentive-compatibility constraint.
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Second-best: optimisation
Problem is then
choose w() to max Eu
b
(q w(q))
subject to Eu
a
(w(q),z) > u
a
.
and E(u
a
(w(q), z)|
z
) + Eu
z
a
(w(q), z) = 0
Lagrangean is
Eu
b
(q w(q)) + [Eu
a
(w(q), z) u
a
]
+ [E(u
a
(w(q), z)|
z
) + Eu
z
a
(w(q), z) ]
is the price on the participation constraint
is the price on the incentive-compatibility constraint
Differentiate Lagrangean with respect to w(q)
each output level has its own specific wage level.
... and with respect to z.
Bill can effectively manipulate Alfs choice of z ...
... subject to the incentive-compatibility constraint.

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Second-best: FOCs
Use a simplifying assumption:
u
xz
a
(,) = 0
Lagrangean is
Eu
b
(x
b
) + [Eu
a
(x
a
, z) u
a
] + [ cE(u
a
(x
a
, z)) / cz ]
where
x
a
= w(q)
x
b
= q w(q)
Differentiating with respect to w(q):
FOC1: u
x
b
(x
b
) + u
x
a
(x
a
, z) + u
x
a
(x
a
, z)|
z
= 0
Differentiating with respect to z:
FOC2: Eu
b
(x
b
)|
z
+ [ c
2
E(u
a
(x
a
, z)) / cz
2
] = 0
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Second-best: results
From FOC2:
Eu
b
(x
b
)|
z

=
c
2
E(u
a
(x
a
, z))/cz
2

> 0
So the incentive-compatibility constraint is binding
From FOC1:
u
x
b
(x
b
) / u
x
a
(x
a
, z) = + |
z
We know that |
z
< 0 for low q...
So if = 0, this would imply LHS negative for low q (impossible)
Hence > 0: the participation constraint is binding.
From FOC1:
Because u
x
b
(x
b
) / u
x
a
(x
a
, z) = + |
z

Ratio of MUs > if |
z
> 0; ratio of MUs < if |
z
< 0
So a-consumption is high if q is high (where |
z
> 0).
|
z
is +ve where
x
b
is large
2
nd
derivative
is negative
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Principal-and-Agent: Summary
In full-information case:
participation constraint is binding
risk-neutral Principal would fully insure risk-averse Agent.
Fully efficient outcome
In second-best case:
(where the moral hazard problem arises)
participation constraint is binding
incentive-compatibility constraint is also binding
Principal pays Agent more if output is high
Principal no longer insures Agent fully.