UNIVERSITY OF ESSEX Department of Economics Economics of Organizational Management

1. UNIVERSITY OF ESSEX Department of Economics Economics of Organizational Management David Reinstein Simple discussion: Moral hazard and the principal-agent relationship

2. Readings Readings: Steven Kerr, “On the Folly of Rewarding A While Hoping for B,” Academy of Management Journal, Vol. 18, pp. 769-83. Roberts, ch. 4. Milgrom and Roberts, Chapter 6, pp. 166 – 181, 185 - 188, Brickley et al., Chapter 15, pp. 412 – 413, These notes! (slides with glasses may be skipped in lecture) See also: Moralhazardlecture1.pdf

3. Moral Hazard • When the other party has private information, two possible problems: • Adverse selection: hidden characteristic • Moral hazard: hidden action

4. Moral hazard • Term originated in insurance industry • Reckless driving in rented car • Many visits to doctor if reimbursed • Ignoring red traffic lights • No safety precautions fire hazards • In all cases, monitoring is impossible, or expertise is lacking, leading to incomplete contracts

5. Examples • An intriguing case of moral hazard occurred with the Savings and loan associations (S&Ls) in the US • Deposits are insured by federal government (FSLIC) • Primary investment mortgages, later also real estate and junk bonds • During 1980s. Real estate market collapsed, junk bonds were undercut • Much fraud in sector • Hardly monitoring • Result: tax bill of hundreds of billion dollars • Reasons: • Government backup led to risky investments • Worsened by competition • No monitoring on fraud “Credit crunch crisis” had a similar but more complicated Moral Hazard Problem (we will return to this)

6. Examples • Another example: Federal crop insurance corporation • Protection of farmers • Not many inspectors • Result: • lots of fraud • Claiming crop losses and selling same harvest • Selling insurance policies after claimed loss occurred • Excessive risk taking

7. Moral hazard within organizations • There are many moral hazard problems within organizations as well • Employees spending time chatting, making telephone call, play games, book holidays on internet • Workers calling in sick • Managers investing in expensive furniture, risky projects. • Etc.

8. Why moral hazard? What sort of incentives lead to moral hazard? How can incentives be set to minimize or avoid moral hazard? Why do we often see incentives “improperly” set, “Rewarding A While Hoping For B” (Kerr, 1975)”?: • Fascination with an ‘objective’ criterion • Overemphasis on highly visible behaviors • Hypocrisy • Emphasis on Moralityor Equity Much of this module: • “Real” limitations on what can be accomplished

9. Principal-agent • We can cast the problems of moral hazard in terms of a principal-agent relationship • This refers to situations where there is a party (the agent) that works on behalf of another party (the principal). • Examples: • Manager and worker (manager is principal) • Shareholder and manager (shareholder is principal) • Government and firm (government is principal)

10. Characteristics of the principal-agent relationship • Principal and agent have conflicting objectives • They can gain from working together • Principal cannot fully verify or monitor agent’s actions

11. Analysis: a simple parametric example We focus on manager-worker relationship Assumptions • Manager risk-neutral • Worker risk-neutral or risk-averse • Output Q of worker depends on effort e and random effect µ: Question: why do you think random effect is introduced?

12. Worker does not like effort. His or her disutility (=cost) of effort is given by e2. Worker can receive either income W with this firm, or 1000 if he works elsewhere Utility of worker is given by: Manager earns profit πoutput minus income given to worker:

13. We focus on linear contracts • S is fixed salary, b is bonus rate • Widely used in practice Cases: • Manager observes effort and gives fixed wage (b = 0) • Manager does not observe effort and “sells the firm’’ • Manager does not observe effort and gives fixed wage (b = 0) • Manager does not observe effort and gives variable wage (b > 0)

14. Observable effortEfficient effort level Suppose Efficient level of effort? Maximize total value: Taking FOC: Salary?

15. e Observable effort, fixed wage Minimum wage accepted Expected output 1000 50

16. Unobservable effortOwnership • Firm can sell rights to output to workers • Workers then maximize own utility • They will choose efficient effort* • Price for the rights?

17. Unobservable effort Here wage must vary in observed output, not in effort! This may complicate things, especially with “risk-aversion” or “limited liability”

18. e Unobservable effort, fixed wage* Optimization?* Cost of effort compensation 0

19. e Unobservable effort, variable wage* 1 Optimization?** Cost of effort compensation 1000 10 *In observable output

20. e Unobservable effort, variable wage 2 Optimization?* Cost of effort compensation 1000 10

21. e Unobservable effort, variable wage 3 Optimization?* Cost of effort compensation 1000 10

22. Lessons Observable effort • Incentive problems are due to conflicts of interest • When effort is observable, actions are contractible, and there are no conflicts of interest • You have to compensate employees for their efforts

23. Lessons Unobservable effort • A higher fixed wage provides no incentives to work harder • Ownership can be good incentive mechanism • To increase effort, pay can be tied to performance (output) • There is a trade-off between paying incentive compensation to increase effort and the associated costs of “inefficient risk bearing”

24. Efficiency and risk-sharing Optimal risk-sharing: if people have different attitudes towards risk, those who are less risk-averse should take a higher burden of risk If firm is risk-neutral and the worker is risk averse, efficiency requires firms carry all risk, and worker carry none

25. ...Efficiency and risk-sharing But this ignores moral hazard problems: • With stochastic output and unobservable/unverifiable effort, to give incentives for effort, workers must face risk • Trade-off between efficiency and incentives

26. How strongly should pay be tied to performance? • If strong, we speak about ‘high-powered incentives’ The following 4 factors favour a strong link between pay and performance: • Value of output is sensitive to employee’s effort • Employee is not very risk averse • (Level of risk is within employees control) • Employee’s response to increased incentives is high

27. Related issues • So far we considered one indicator of effort: output • In reality, there are often more • Input prices • Output other workers • Output other firms • Number of defects • Etc. • A basic result, known as the informativeness principle, says that in an optimal contract, all information should be used • Intuition: using more indicators increases precision of output measure. This reduces uncontrollable risk.

28. Does it work? Examples • In, October 1988 Du Pont changed it’s payment schedule for nearly all 20,000 employees (including management) • 6 percent of annual pay was placed into a ‘at-risk pool’ • If business exceeded goals, employees would receive a multiple of the money as bonus • If business did not meet goals, employees would lose money • For instance, the fibers division had to achieve target of 4 percent real-earnings growth to recover their at-risk pay

29. Was this plan a good one? • Poor economy led to high input prices and employees lost monies placed in bonus pool • Employees were unhappy • Design problems of plan: • Individual effort only small impact on output • Profits dependent on many random factors outside control employees • No additional information used • Earnings-growth relative to other firms in industry • Market conditions

30. Lazear (2000, AER) studied reward schemes of the Safelite Glass Corporation • They changed from hourly wage rates to piece-rates • Results: on average 44 percent higher output per worker, of which • Half due to incentive effects (workers producing more) • Half due to self-selection effects (hiring more productive workers)

31. The Allen-Edmonds Shoe Company changed from piece rates to hourly wages • That year, they lost $1 mln FURTHER EXAMPLES IN READINGS