Creating Contracts to Avoid Moral Hazard

Module 4 Introduction In this module, you will have the opportunity to master the following competency:

• Demonstrate how economic theory contributes to strategic managerial

decision-making.

Further, the content in this module will help you achieve the following learning

objectives:

• Assess the degree of risk and expected profit from a financial

investment.

• Evaluate how attitudes toward risk affect choice under uncertainty, and

actions that decision makers can take to reduce their risk.

• Evaluate the ways adverse selection and moral hazards prevent

desirable transactions, and methods that can reduce adverse selection

and moral hazards.

• Create contracts that reduce or eliminate moral hazard.

• Assessing Risk and Expected With every investment decision, there is a degree of risk, as well as a certain amount of profit to be gained. The degree of risk can be quantified by

calculating the probability that an event will or will not occur. We can then

use these probabilities to calculate the expected profit from an investment.

With any event that could occur, there is a certain probability between zero

and one that is associated with its occurrence. If there were 0% chance the

event would occur, the probability would be zero. If we are 100% certain this

event will occur, the probability will be one. Similarly, a 50% chance of

occurrence would have a probability of 0.5, a 30% chance of 0.3 and so forth.

Whenever we look at a series of events, we will see that their probabilities will

add up to 1.0, but they must be mutually exclusiveand exhaustive. Imagine

that we are flipping a coin. There are two possible outcomes: heads or tails.

These events are mutually exclusive in that you can obtain a head or a tail,

but you cannot obtain both on the same flip. They are also exhaustive, since

there is no third possibility. Hence, each possible event will have a probability

of 0.5 and will add up to 1.

Now, imagine rolling a six-sided dice. There are six possible outcomes, with

an equal probability of rolling a one, two, three, etc. Hence, the probability of

each outcome is one out of six, or 1/6. These events are mutually exclusive

and exhaustive, so the probabilities will add up to 1.

Once we know the probabilities of our outcomes, as well as the potential profit

to be earned, we can calculate the expected value as follows, where n is the

number of outcomes, Prn is the probability of the nth outcome, and Vn is the

value of the nth outcome:

EV = Pr1V1 + Pr2V2 + ... + PrnVn

The calculation for expected value weights each are valued (V1, V2, etc.) by

its respective probability of occurrence (Pr1, Pr2, etc.), and these weights are

then summed together.

To see this in action, let us say Jeff is offered the chance to roll a dice. If he

rolls an odd number, he receives the amount of the roll in dollars ($1, $3, or

$5). If he rolls an even number, he must pay the amount of the roll in dollars

($2, $4, or $6). Right away, we can see that this probably is not a good bet,

but let us calculate the expected value to see for sure. First, we weight the

probabilities of each roll with their respective values.

EV = Pr1V1 + Pr2V2 + Pr3V3 + Pr4V4 + Pr5V5 + Pr6V6

Since each roll has a probability of 1/6:

EV = (1/6) ($1) + (1/6) (-$2) + (1/6) ($3) + (1/6) (-$4) + (1/6) ($5) + (1/6) (-$6)

Note that a loss has a negative value and that a gain has a positive value.

This simplifies to:

EV = $1/6 - $2/6 + $3/6 - $4/6 + $5/6 - $1 = - 3/6 = - $0.50

Playing this game a repeated number of times would yield an expected value

of a 50-cent loss. While expected value is obviously a good number to know if

he plays the game repeatedly, it does not tell us how risky an investment is,

were he to play the game just once. This is where the variance comes into

play.

Let us say Jeff is then offered the chance to play a similar game, but this time

the value of the roll results in that amount being won when 1-5 are rolled ($1,

$2, $3, $4, or $5). However, Jeff will lose $18 by rolling a six. Calculate the

expected value on your own to see that the second game has the same

expected value as the first.

Clearly, however, these two games do not carry the same risk. To find the

risk, use the formula for variance below:

Var(σ2) = Pr1(V1−EV)2 + Pr2(V2−EV)2 + ... + Prn(Vn−EV)2

To find the variance, take the difference between each outcome's value and

the expected value of playing the game. This figure is squared then weighted

by that outcome's respective probability. All figures are then summed to yield

the variance of the game. A higher variance indicates higher risk, while lower

variance indicates lower risk. In the business world, standard deviation (σ) is

often reported rather than variance. Simply take the square root of σ2 to

obtain σ.

Attitudes Toward Risk As you may have noticed, different people have different attitudes toward risk. They can be risk-aversive, risk-neutral, or risk-preferring.

In order to determine which category an investor falls into, look at their

willingness to place a fair bet. A fair bet is an investment in which the

expected value is zero. An example of this would be flipping a coin, where you

pay a dollar if you get heads and you gain a dollar if you get tails. A risk-

neutral person looks only at the expected value, so they’re indifferent to taking

the bet. Most people, however, are risk-aversive. Despite this being a fair bet,

they will be unwilling to take the bet because they do not like risk. Conversely,

some people love risk, as evidenced by the multitude of gambling institutions.

These investors would be considered risk-preferring and would always take

the fair bet.

In an ideal world, managers would be risk-neutral and would be expected to

maximize expected profit. However, managers come to the table with their

own attitudes toward risk, which can sometimes cause them to make risk-

averse or risk-preferring decisions, even if shareholders prefer risk-neutral

decisions. Since managers are essentially gambling with other people’s

money, they may not be inclined to always act in the shareholder’s best

interest. The manager may be concerned about losing their job if a large loss

occurs and may be afraid to take a fair bet. The manager may also be looking

at short-run profits that will benefit themselves, while setting the company up

for financial troubles in the long run.

There are several things managers can do to decrease risks. First, they can

obtain as much information as possible about potential investments. They can

also decide to purchase insurance. Since risk-aversive individuals are willing

to pay a risk premium to avoid risk, it makes sense that they would also be

willing to pay for insurance that effectively transfers the risk from the individual

to the insurance company.

One of the most important ways for an investor to reduce or eliminate risk is

through diversification. Diversification involves placing investments into

different firms, different industries, and even different countries, with the

intention of negating some of the diversifiable risk. There are two main types

of risk:

1. Systematic

2. Unsystematic risk

Systematic Risk: This is essentially the risk involved with the economic

system. Whenever there is a major economic event such as a recession or an

economic boom, there will be widespread changes to the economy as a

whole. It is very difficult to reduce systematic risk by diversifying our portfolio.

In fact, other names for this type of risk are undiversifiable risk, or market

risk.

Unsystematic Risk: This type of risk is also called diversifiable risk, or

specific risk. This is risk that applies to a limited segment of investments. It

could apply to risk in one firm, such as when laborers go on strike. It could

also apply to one industry, such as the oil industry if a very cheap source of

alternative energy were developed. Unsystematic risk could just impact one

country. However, even if an economic upset occurs in one specific country,

you could see an additional risk with your other assets. We live in a globalized

world where major economic events in one country tend to traverse to

another. Regardless, some economic events will impact the economy in one

country much more than the rest of the world. Hence, it is still advisable to

diversify your portfolio by investing not only in different firms and different

industries, but also in different countries.

In addition to diversifying across several firms, industries, and countries, your

portfolio should also be spread amongst several types of investment

instruments. Some should be kept as cash, and some as stocks or bonds, and

some as mutual funds. You may also consider investments such as rental real

estate or land.

Rather than only choosing safe investments, or only choosing riskier

investments, you should consider a combination of both conservative and

aggressive investments. Conservative investments have lower risk and lower

expected returns, while aggressive investments have higher risk and higher

returns. Diversifying between the two ensures that some of your investment is

yielding a high return, with the remainder safeguarded. While diversification is

important, investment managers also recommend a portfolio with a higher

percentage of aggressive investments at a younger age, when you can afford

to start over; moving more of your wealth to conservative investments as you

move closer to retirement.

Reducing Moral Hazard Through Moral hazards occur when one party bears all of the risk of an operation. After a financial transaction takes place, the other party may change their

behavior to the detriment of the other party. Because one party bears all of the

risk, this increases the incentive for the other party to act negligently.

Typically, the moral hazard occurs because an agent, such as an employee,

does not always act in the best interest of the principal, such as an employer.

The principal cannot closely monitor his agent. This is called the principal-

agent problem and is a common issue faced by business managers.

One way to reduce moral hazards is through carefully designed contracts.

There are two types of contracts that are commonly utilized to reduce or

eliminate moral hazard: fixed-fee contracts and contingent contracts.

Fixed-fee Contracts

Let us say that Sue owns a hair salon and hires Jeff to cut hair at her salon. If

Jeff is paid by the hour, he has little incentive to perform his best work. Sue

will bear the costs as her business’s reputation suffers along with her profits.

In this case, Sue bears all of the risk of Jeff’s hairstyling skills, while Jeff

himself bears no risk. In order to prevent this, Sue can charge Jeff $250 a

month for a chair at the salon, allowing him to keep all residual profits. This is

called a fixed-fee contract. Jeff’s take home pay increases if he uses more of

his skills while on the job. There is also a transfer of risk in this situation, as

Jeff now bears all of the risk while Sue bears none.

Contingent Contracts

Another type of contract used to reduce moral hazard is a contingent

contract, in which payment from the principal to the agent is contingent on

some condition being met. There are several types of contingent contracts.

State-Contingent Contracts

In a state-contingent contract, one party’s payoff is contingent on only the state of nature. For example, let us say Sue’s hair salon is located near a ski resort in a town with a small population. Both Sue and Jeff know that there is a huge increase in demand during the winter months, with a sharp drop-off in demand in the summer months. Jeff would like to continue working in the summer, but may not be able to afford the steep rental price. Sue would rather have Jeff work during the summer at a lower rental cost then have an empty chair in her salon during those months. The two can work out a contract that is contingent upon demand, where Jeff pays $250 a month during the winter and $100 during the summer. However, a state-contingent contract depends on both parties agreeing on the state of nature.

Profit-Sharing Contracts

With a profit-sharing contract, the agent receives some of the overall profit. Rather than rent a chair, Jeff would receive some of the overall profit that Sue’s business earns. This will encourage Jeff to work hard, but only if the percentage of profit received is great enough to offset the additional work he must do in order to obtain it. This contract may not work if there is a new stylist, Mark, who does not receive a share of the profit. He does not have any incentive to work harder, so Jeff must work extra hard in order to make up for Mark’s laziness. Jeff may not have the incentive to invest his time and resources if the profit-sharing percentage is too small.

Bonuses and Options

Sue could also offer Jeff a bonus if profits exceed a certain amount, or she could offer him stock options in the company. As the company profits increase, so will the value of Jeff’s stock, encouraging him to work harder.

Piece Rates and Commissions

The final type of contingent contract is a piece-rate contract. Here, the agent receives a payment for each unit of output the agent produces. For every haircut that Jeff gives, he receives a certain rate. Sue could also pay him a commission, or percentage, of each sale. This would be better for a company where speed is essential in an operation. However, the hair salon will greatly depend upon the quality of the service as well, and Sue may not want to stake her business’s reputation. This also does not allow for

uncertainty for fluctuations in demand. Jeff will still receive significantly less during the summer months when the tourism industry dies down.