Economics, Organization
and Management
Chapter 6: Moral Hazard and
Performance Incentives
Joe Mahoney
University of Illinois at Urbana-Champaign
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

Examples of Moral Hazard:
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When those with critical information have interests
different from those of the decision maker, they may
fail to report completely and accurately the information
needed to make good decisions.
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When buyers cannot easily monitor the quality of the goods
or services that they receive, there is a tendency for some
suppliers to substitute poor quality goods or to exercise too
little effort, care or diligence in providing the services.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

Moral hazard is the form of post-contractual opportunism that
arises because actions that have efficiency consequences are not
freely observable and so the person taking them may choose to
pursue his or her private interests at others’ expense.

The term moral hazard originated in the insurance industry,
where it referred to the tendency of people with insurance to
change their behavior in a way that leads to larger claims against
the insurance company. For example, being insured may make
people lax about taking precautions to avoid or minimize losses.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

Hidden Action (moral hazard) or Hidden Information (adverse selection)?
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Although moral hazard and adverse selection seem distinct in textbook
discussions, in practice it may be difficult to determine which is at work.
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Example: A larger fraction of Volvo drivers went through stop signs in
the Washington D.C. area. Why?
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Moral Hazard: People driving Volvos feel particularly safe in this
sturdy well-built, crash-tested car. Thus they are willing to take risks.
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Self-Selection: People who buy Volvos know that they are bad
drivers who are apt, for example, to be giving more attention
to their children in the back seat than to stop signs.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

The Principal-Agent Relationship. The term principal-agent has
come to be used in organizational economics to refer to situations
in which one individual (the agent) acts on behalf of another (the
principal) and is supposed to advance the principal’s goals. The
moral hazard problem arises when agent and principal have
differing individual objectives and the principal cannot easily
determine whether the agent’s reports and actions are being taken
in pursuit of the principal’s goals or are self-interested misbehavior.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

The Principal-Agent Relationship.
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Agency Relationships are pervasive:
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The doctor is the agent to the patient;
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The worker is the agent of the firm; and
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The CEO is the agent of the owners.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

An important instance of moral hazard arises in employment
relationships, where employees may shirk their responsibilities.

Evidence of the importance of moral hazard in the employment
relationship is the frequency with which firms give employees
compensation to various measures of performance, and are meant
to motivate effort, creativity, care, diligence and so on.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

Berle and Means (1932) maintained that the dispersed holdings of
stocks across a multitude of small investors had created an effective
separation of ownership and control, with no individual
stockholder having any real incentive to monitor managers and
ensure that the officers and board were running the firm in the
owners’ interests.
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The problem typically is not that the executives are lazy and do not
work hard enough. Corporate executives typically work remarkably
long hours of very intense effort. Rather, the complaint is that they
pursue goals other than maximizing the long-run value of the firm.
Critics claim that executives invest firms’ earnings in lowvalue projects to expand their empires when the funds
would be better distributed to the shareholders to invest
for themselves.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

In order for a moral hazard problem to arise, three conditions
must hold:
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There must be some potential divergence of interests between
people;
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There must be some basis for gainful exchange or other cooperation
between the individuals; and
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There must be difficulties in determining whether in fact the terms
of the agreement have been followed and in enforcing the
contract terms. These difficulties often arise because
monitoring actions or verifying reported information is
costly or impossible.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management
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The first remedy for moral hazard problems is to increase the resources
devoted to monitoring and verification.
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The second remedy for moral hazard problems is that managers who do
a poor job in competitive product and input markets will face greater
probability of unemployment, and reduced reputation.
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The third remedy is the “market for corporate control” (i.e., takeovers).
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A fourth remedy is explicit incentive contracts that balance the
costs of risk-bearing against the benefits of improved performance.
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A fifth remedy is an economic bond (collateral) to ensure
performance.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management

The efficiency of the size of the firm is limited, in part, by
influence activities.
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Influence activities arise in organizations when organizational
decisions affect the distribution of wealth or other benefits
among members or constituent groups of the organization
and, in pursuit of their selfish interests, the affected
individuals or groups attempt to influence the decision to
their benefit. The costs of these influence activities are
influence costs.
Milgrom and Roberts (1992): Chapter 6
Economics, Organization & Management
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When two previously separate organizations are brought under
a common central management with the power to intervene,
the scope for influence costs increase. For example, members
of one unit can try to influence top management to transfer
resources from the other unit to their unit.
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Large amounts of time, ingenuity, and effort may go into
these attempts at influence, and huge amounts of the central
executives’ time can be consumed dealing with these influence
activities.