Concept explainers
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.
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.
Want to see more full solutions like this?
Chapter 15 Solutions
EBK INTERMEDIATE MICROECONOMICS AND ITS
- Explain several dimensions of the shareholder-principal conflict with manageragents known as the principal-agent problem. To mitigate agency problems betweensenior executives and shareholders, should the compensation committee of the boarddevote more to executive salary and bonus (cash compensation) or more to longterm incentives? Why? What role does each type of pay play in motivatingmanagers?arrow_forwardExplain the relationship between moral hazard and insurance premiumsarrow_forwardThe problem of adverse selection in insurance markets means that it is generally a bad deal for companies to offer insurance at the same price for all potential customers. Why then do we observe some insurance companies (such as those selling “trip insurance” that refunds money to people who purchase trips that they are unable to take) do exactly this?arrow_forward
- Someone indicated that employee’s absence from work despite meeting the eight hours per day requirement affect productivity and increase cost of business. If an employee makes up the hours by coming early and leaving late, how can you call it an example of moral hazard when the manager can easily correct this behavior? Please explain to the class.arrow_forwardSuppose American sugar producers convince the federal government to issue a directive to put a tariff on foreign sugar. This would be an example of the principal-agent problem. logrolling. rent-seeking. moral hazard.arrow_forwardDescribe the principal-agent problem between firm owners and managers. Make sure you identify the principal and the agent and discuss the information asymmetries and different goals of the two players.arrow_forward
- Not long ago, the Federal Communications Commission (FCC) implemented “local number portability” rules allowing cellular phone consumers to switch cellular providers within the same geographic area and maintain the same phone number. How would you expect this change to affect the Rothschild index for the cellular service industry?arrow_forwardThe text points out that asymmetric information can have deleterious effects on market outcomes. a. Explain how asymmetric information about a hidden action or a hidden characteristic can lead to moral hazard or adverse selection. b. Discuss a few tactics that managers can use to overcome these problems.arrow_forwardQ1) In September 2013, Tokyo Electric Power Company (Tepco) reported highly contaminated water leaking from a storage tank at the Fukushima nuclear power plant crippled in a March 2011 earthquake and tsunami. From what you know of the ongoing Fukushima disaster, discuss the various stakeholder groups that Tepco should respond to in order to handle this latest crisis. Q2) Is it ethical and socially responsible for large corporations to lobby against an SEC rule requiring that they report the ratio of their CEOs’ pay compared to that of their average employee, as described in the chapter? Discuss. Q3) A survey found that 69 percent of MBA students view maximizing shareholder value as the primary responsibility of a company. Do you agree? What do you think this finding suggests about the ethical and socially responsible stance of corporate managers over the next couple of decades? Should We Go Beyond the Law? Nathan Rosillo stared out his…arrow_forward
- As it applies to insurance, the moral hazard problem is the tendency for: those most likely to collect on insurance to buy it. those who buy insurance to take less precaution in avoiding the insured risk. sellers to price discriminate. sellers to restrict output and charge high prices.arrow_forwardWhich is CORRECT about information asymmetry and adverse selection 1. Information asymmetry refers to the situation when buyers have more information on the product than the sellers. 2. Information asymmetry is the result of adverse selection. 3. In a used car market, if sellers with good cars are unwilling to sell at a large discount, then only bad cars will get sold. This suboptimal outcome is so-called “adverse selection”. 4. Due to information asymmetry, market investors interpret firm’s SEO announcement positively because they believe insiders consider the firm undervalued.arrow_forward
- Managerial Economics: A Problem Solving ApproachEconomicsISBN:9781337106665Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike ShorPublisher:Cengage LearningManagerial Economics: Applications, Strategies an...EconomicsISBN:9781305506381Author:James R. McGuigan, R. Charles Moyer, Frederick H.deB. HarrisPublisher:Cengage Learning