‘I know something you don’t know’. This statement is a common boast among children but it also conveys a deep truth about how people sometimes interact with one another. Many times in life, one person knows more about what is going on than another. A difference in access to relevant knowledge is called an information asymmetry.
A worker knows more than his employer about how much effort he puts into his job. A seller of a used car knows more than the buyer about the car’s condition. The first is an example of a hidden action whereas the second is an example of a hidden characteristic. In each case, the uninformed party (the employer, the car buyer) would like to know the relevant information, but the informed party (the worker, the car seller), may have an incentive to conceal it.
Moral hazard is a problem that arises when one person, called the agent is performing some task on behalf of another person called the principal. If the principal cannot perfectly monitor the agent’s behaviour, 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 behaviour by the agent. In such a situation, the principal tries various ways to encourage the agent to act more responsibility.
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.
According to efficiency–wage theories some employers may choose to pay their workers a wage above the level of supply and demand in the labour 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.
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. 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.
A homeowner with fire insurance will be likely to 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 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.
Much production in the modern economy takes place within corporations. Like other firms, corporations buy inputs in markets for the factors of productions and sell their output in markets for goods and services. Also like other firms, they are guided in their decisions by the objective of profit maximization. But a large corporation has to deal with some issues that do not arise in a small family-owned business.
From a legal standpoint, a corporation is an organization that is granted a charter recognizing it as a separate legal entity, with it owns rights and responsibilities distinct from those of its owners and employees. From an economic standpoint, the most important feature of the corporate form of organization is the separation of ownership and control. One group of people, called the shareholders, own the corporation and share in its profits. Another group of people called the managers are employed by the corporation to make decisions about how to deploy the corporation’s resources.
The chief executive officer and other managers are in the best position to know the business opportunities that are available, and they are charged with the task of maximizing profit for the shareholders. But ensuring that they carry out this task is not always easy. The managers may have goals of their own, such as taking life easy, having a plush office and a private jet, throwing lavish parties, or presiding over a large business empire . The managers’ goals may not always coincide with the goal of profit maximization.
The corporation’s board of directors is responsible for hiring and firing the top management. The board monitors the managers’ performance and it designs their compensation packages. Managers might be given bonuses based on performance or options to buy the company’s stock, which are more valuable if the company is doing well.