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Moral Hazard (Hidden Action Problem)
Incentive Alignment as a Partial Solution to Hidden-Action Problems
A partial solution to hidden-action problems involves the principal structuring incentives, such as requiring equity or an insurance excess, to motivate the agent. However, these measures do not fully resolve the issue, as the agent's interests will still not be perfectly aligned with those of the principal.
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Social Science
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CORE Econ
Economics
Economy
Introduction to Microeconomics Course
The Economy 2.0 Microeconomics @ CORE Econ
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The Employer-Employee Relationship as a Principal-Agent Problem
Origin of the Term 'Moral Hazard' in Insurance
Role of External Uncertainty in Moral Hazard
Differentiating Negligence from Bad Luck in Insurance Claims
Incentive Alignment as a Partial Solution to Hidden-Action Problems
Moral Hazard in Labor Markets
Contractual Limits in Insurance to Mitigate Moral Hazard
Incompleteness of Insurance Contracts due to Hidden Actions
Market Failure as a Consequence of Hidden Actions
Agent's Decision on Care: Social vs. Private Benefit
Learn After
Efficiency Wages as an Incentive for Employee Effort
A tech company hires a marketing manager to run a new advertising campaign. The company's board cannot directly observe the manager's daily strategic decisions or effort level. The campaign's success is influenced by both the manager's skill and unpredictable changes in consumer trends. To motivate the manager, the company offers a compensation package that includes a competitive base salary plus a bonus tied to the campaign's measured increase in market share. Why might this incentive structure be considered only a partial solution for aligning the manager's actions with the board's goal of maximizing company value?
Evaluating an Insurance Contract
Evaluating an Incentive Contract
If a business owner makes a manager a part-owner by granting them a substantial equity stake, the problem of the manager not acting in the owner's best interest is fully resolved. This is because both parties now have a shared goal of maximizing the firm's profitability.
The Limits of Incentive-Based Contracts
A principal can design contracts to motivate an agent whose actions are not fully observable. However, these solutions are often imperfect. Match each incentive mechanism below with the primary reason it only partially aligns the agent's interests with the principal's.
Founder Incentives in a Venture-Backed Startup
A company compensates its CEO with a large bonus tied directly to the firm's annual profit. This incentive structure is intended to motivate the CEO to act in the shareholders' best interests. However, the alignment is imperfect because the firm's profit is influenced not only by the CEO's decisions and effort but also by unpredictable ____, which makes it impossible to design a bonus scheme that rewards only the CEO's true contribution.
A startup founder wants to hire a CEO to manage the company's growth. The founder cannot directly monitor the CEO's daily effort or strategic decisions, and the company's success is also affected by unpredictable market forces. Arrange the following CEO compensation structures in order from the one that creates the least alignment to the one that creates the most alignment between the CEO's (agent's) actions and the founder's (principal's) goal of maximizing long-term company value.
Franchise Incentive Structure Analysis