Chapter 15, Problem 1RQ

To determine

To explain:

Way to remove trade-off between incentives and risk and also ways to reduce moral hazard problem.

Explanation of Solution

Due to negligence of manager’ effort, problem of moral hazard arises. Moreover, if the manager is risk-averse then the moral hazard problem become further accentuated.

Given the above context and also assuming that there exists a trade-off between risk and incentives, it would be difficult to reach an efficient outcome where the marginal pay of the manager is equal to the marginal cost of manager’s effort. This is due to the presence of asymmetric information which links the managers pay to firm's performance (or gross profit) and not his effort. As a result the manger is exposed to risk which is associated with the uncertain gross profits of the firm. This will give rise to two situations: (1) manager will choose less salary for less risk; and (2) on the other hand, the risk-averse manager will not accept high-powered incentive contract compelling the shareholders to pay a higher fixed salary to the manager to accept the risk.

The moral-hazard problem can be eliminated if the effort of the manager is directly observable by simply linking the manager's effort to the manager’s pay. This is because when the effort is observable, the shareholders know that manager's effort is in his control and there is no uncertainty as such.

If the effort is unobservable and the manager is risk-neutral, then the problem of moral-hazard problem can be eliminated by paying incentives for the effort of managers if shareholders gross profit increases.

Economics Concept Introduction

Introduction:

Moral hazard is a feature of market failure in which an individual tries to expose himself to risk when he is not bearing the full cost of risk.