Moral Hazard and Least-Cost Contracts: Impact of Changes in Conditional Probabilities
Moral Hazard and Least-Cost Contracts: Impact of Changes in Conditional Probabilities
Moral hazard (often called hidden action) arises when one party (a principal) hires another party (an agent) who undertakes unobservable effort. The agent's effort is stochastically related to the outcomes or profits of the principal. Because the effort is not observable or verifiable, the agent can only be paid a wage contingent upon the observable variable, such as whether a sale occurred or not. If a profit-maximizing principal wants the agent to work hard, she must provide a contract that (i) induces the agent to accept it, and (ii) induces the agent to work hard rather than shirk. The former is often called "individual rationality" or "participation constraint" and is satisfied if the agent's expected utility is at least equal to his reservation utility. The latter is called "incentive compatibility" and is satisfied if the agent's expected utility from working hard is at least equal to his expected utility from shirking.