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M21.L02 — Moral Hazard and Principal-Agent Problems

Module: Module 21 — Information Asymmetry and Synthesis Lesson: L02 of 05 Duration: ~30 minutes Level: Intermediate Provenance: Principles of Microeconomics (Curtis and Irvine) | University of Utah Intermediate Microeconomics

Learning Objective

Analyze optimal contract design under moral hazard.

Principal-Agent Problems

Moral hazard occurs when one party (agent) can take hidden actions that affect another (principal) after a contract is signed. Classic examples:

  • Employer (principal) cannot observe worker (agent) effort
  • Insurer (principal) cannot monitor insured (agent) risk-taking

In Australia:

  • Workplace productivity contracts
  • Financial advisor incentives
  • Insurance deductibles

The principal's problem is to design a contract that:

  1. Satisfies participation constraint (agent willing to work)
  2. Satisfies incentive compatibility constraint (agent prefers working to shirking)

Mathematically, maximize principal's expected profit subject to:

PC: E[u(w(e)) - c(e)] ≥ ū IC: e ∈ argmax E[u(w(e)) - c(e)]

Worked Example

[Australian context]

Consider an Australian construction company (principal) hiring a subcontractor (agent):

  • High effort (e=1) costs $200 but ensures on-time completion
  • Low effort (e=0) costs $0 but risks delays (50% chance of $1000 penalty)

Optimal contract must satisfy:

PC: w - 200 ≥ 0 IC: w - 200 ≥ 0.5w + 0.5(w - 1000)

Solving yields w ≥ $1200 for high effort to be optimal.

Common Misconception

"Moral hazard means the agent is being immoral"

Correction: Moral hazard describes incentive misalignment, not moral judgment. It's about observable vs unobservable actions, not ethics.

Key Takeaways

  • Hidden actions create moral hazard
  • Contracts must balance participation and incentives
  • Efficiency wages may be necessary
  • Performance-based pay aligns incentives

Practice

  1. Derive the optimal wage for the construction example if the delay penalty increases to $2000.
  2. Why might Australian banks use clawback provisions in executive pay?
  3. How does workers' compensation insurance create moral hazard?

Further Resources

Provenance: Principles of Microeconomics (Curtis and Irvine) | University of Utah Intermediate Microeconomics