Adverse Selection or Moral Hazard
Rick’s Iron Skillet on South
School changed formats and now
offers a lunch buffet. The
management has noticed that
the average consumption of
customers has increased.
Adverse Selection or Moral Hazard
An 8 year old acquires a credit
card, runs up large bills online
and refuses to pay.
Adverse Selection or Moral Hazard
The IMF helps bail out
countries that experience
financial crises.
Adverse Selection or Moral Hazard
Wal-Mart has noticed that
employees who stay employed
longer tend to be in poorer
health and thus have higher
health care costs.
Contracting
When we can’t perfectly monitor what
someone does, we want compensation
and choices to be connected.
e.g. selling the worker the right to the output.
(franchising)
Risk Concerns
Expected Output = 6e1/2 + e
where e is a random component.
What will happen to selling price if worker
is risk averse?
no random component – selling price was $193
Optimal Risk Sharing
• Most individuals are risk averse
– for given income level, prefer less dispersion
in outcomes
• Shareholders have diverse portfolios
– less concerned about performance of any one
company
• Employees receive substantial income
from single company
Contracts and Risk
Contracts
provide incentive and
share risk
Wage = B0+B1Output
B0+B1(6e1/2 + e)
Selling rights to output essentially had
B0=-193 and B1=18 (the market price).
Contracts and Risk
(Risk Neutral) Worker’s Problem:
Maximize payoff = B0+B1(6e1/2 + e) - e2
B0+B16e1/2 + B1e - e2
dp/de= (1/2)B16e-1/2 - e2 =0
which does not depend on B0
So changing flat component will not impact effort, but changing
incentive component will.
Other Forms of Incentives
Bonus for exceeding thresholds
Gold Stars and other prizes
Firing for bad performance
Others??
Evaluating Individual Performance
Setting Benchmarks (Relative v Absolute)
Time and Motion Studies
Past Performance
Perverse Incentives
the Ratchet Effect – if targets adjust
based on this period’s performance, then
employees do not want to set the bar to
high.
Evaluating Individual Performance
Perverse Incentives
gaming – teaching to the test
- giving discounts to customers to
delay orders
- not helping coworkers
- sitting on a research paper
- peer pressure not to blow the curve
horizon - typically trades long run for short run.
Subjective Performance Evaluation
• Multiple tasks and unbalanced effort
• Subjective evaluation methods
– Standard rating scales
– Goal-based systems
• Problems
– Supervisor shirking
– Forced distribution
– Influence costs
– Reneging
Performance
Optimal evaluation is some combination of
objective and subjective components.
(Depends on marginal cost and marginal benefit
of specific situation)