HIDDEN ACTIONS PRINCIPALS AGENTS AND MORAL HAZARD

Moral hazard is a problem that arises when one person, called the agent, is performing some task on be half of another person called the principal If the principal cannot perfectly monitor the agent’s behavior the agent tends to undertake less effort than the principal considers desirable. The phrase moral hazard refers to the risk, or “hazard,” of inappropriate or otherwise “immoral” behavior by the agent. In such a situation, the principal tries various ways to encourage the agent to act more responsibly The employment relationship is the classic example. The employer is the principal, and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to shirk their responsibilities Employers can respond to this problem in various ways:Moral hazard is a problem that arises when one person, called the agent, is performing some task on be half of another person, called the principal. If the principal cannot perfectly monitor the agent’s behavior, the agent tends to undertake less effort than the principal considers desirable. The phrase moral hazard refers to the risk, or “hazard,” of inappropriate or otherwise “immoral” behavior by the agent. In such a situation the principal tries various ways to encourage the agent to act more responsibly
The employment relationship is the classic example. The employer is the principal, and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to shirk their responsibilities. Employers can respond to this problem in various ways.

• Better monitoring. Parents hiring nannies have been known to plant hidden video cameras in their homes to record the nanny’s behavior when the parents are away. The aim is to catch irresponsible behavior.

• High wages. According to efficiency-wage theories (discussed in Chapter 19), some .employers may their workers a wage above the level that supply and demand in the labor market. A worker who earns an above-equilibrium wage is less likely to shirk because, if he is caught and fired, he might not be able to find another high-paying job Delayed payment. Firms can delay part of a worker’s compensation, so if the worker is caught shirking and is fired, he suffers a larger penalty. One example of delayed compensation is the year end bonus Similarly, a firm may choose to pay its workers more later in their lives. Thus, the wage increases that workers get as they age may reflect not just the benefits of experience but also a response to moral hazard.

These various mechanisms to reduce the problem of moral hazard need not be used alone. Employers can use a combination of them Beyond the workplace, there are many other examples of moral hazard. A homeowner with fire insurance will likely buy too few fire extinguishers because the homeowner bears the cost of the extinguisher while the insurance company receives much of the benefit. A family may live near a river with a high risk of flooding because the family enjoys the scenic views, while the government bears the cost of disaster relief after a flood. Many regulations are aimed at addressing the problem. An insurance company may require homeowners to buy extinguishers, and the government may prohibit building homes on land with high risk of flooding. But the insurance company does not have perfect information about how cautious homeowners are, and the government does not have perfect information about the risk that families undertake when choosing where to live. As a result, the problem of moral hazard persists.

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