lecture2 - Econ 103C-Lecture 2 Moral Hazard David Sraer U.C...

Info iconThis preview shows pages 1–7. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Econ 103C-Lecture 2 Moral Hazard David Sraer U.C. Berkeley January 25, 2008 David Sraer (U.C. Berkeley) Econ 103C-Lecture 2 January 25, 2008 1 / 62 Introduction Two parties, usually of their own choosing, enter into a situation in which their interests are intertwined. The actions of one of the actors (the agent) exerts an externality on the utility of the other (the principal). Not surprisingly, the principal will want to influence the agent’s actions. To do so, she can write a contract for how to handle their interaction. Then, the agent takes an action, and the relevant outcomes are realized. David Sraer (U.C. Berkeley) Econ 103C-Lecture 2 January 25, 2008 2 / 62 Where does moral hazard comes from? Originally, the literature on insurance recognized this general class of problems. In fact, the dictionary definition of moral hazard is: Moral hazard : A risk to an insurance company resulting from uncertainty about the honesty of the insured. Underlying idea: if a company insures an asset, the insured party does not have the incentive to maintain the asset properly. Perfect example: car insurance. Question: how the insurance company can influence the driver’s action with the design of the insurance contract? Issue: the behavior of the driver is unobservable by the insurance company. Solution: some outcomes are observable and verifiable in court, e.g. the amount of the loss in an accident = ⇒ use of a deductible! David Sraer (U.C. Berkeley) Econ 103C-Lecture 2 January 25, 2008 3 / 62 “Real world” examples As we already discussed, real life is full of situations involving moral hazard: Employer and Employee . Impossible to write contracts such as “we will not pay you if you slack off”, thus use of performance-based contract such as commission or bonus. Issue: these outcomes might depend on more than agent effort (luck). Homeowner and Contractor . Landlord and Tenant . Professor and Student . Why do you think do we have exams? Entrepreneur and outside finance . Project choice. David Sraer (U.C. Berkeley) Econ 103C-Lecture 2 January 25, 2008 4 / 62 Ingredients of moral hazard models The key ingredients of the typical moral hazard setting are: Two parties, a principal and agent. Agent’s action affects principal’s utility. Action is not observable. The action determines (usually stochastically) some performance measure. The parties can agree ex ante to a reward schedule by which the principal pays the agent (i.e. they can enforce a contract). This reward schedule can only be a function of verifiable performance measures. We are going to see the traditional moral hazard model in the case of an employment relationship. David Sraer (U.C. Berkeley) Econ 103C-Lecture 2 January 25, 2008 5 / 62 Two outcome model: the setup We begin with a simple model: The agent can exert a continuous level of effort e ∈ R + at a cost c ( e ) where c is a C 2 function, strictly increasing and weakly convex....
View Full Document

This note was uploaded on 08/01/2008 for the course ECON 103C taught by Professor Sraer during the Spring '08 term at Berkeley.

Page1 / 63

lecture2 - Econ 103C-Lecture 2 Moral Hazard David Sraer U.C...

This preview shows document pages 1 - 7. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online