Maxine,
Let me give you a brief overview of "moral hazard" using both my own
knowledge as well as linking you to some resources I found by doing a
google search for :
"moral hazard" upside downside potential
Here's my personal (ie. try to reword it before you use it yourself)
definition of Moral Hazard :
Moral hazard is the potential risk incurred by delegating a task to a
self centered individual. At its core is the assumption that given the
choice, people will do what is best for themselves rather than what is
best for the people they interact with.
Technically it is the answer to the question "how much do the
incentives that I would like an individual to follow differ from the
ones that are best for them".
The classic example in corporate finance theory is that of a manager
who decides how to spend the money of a firm. He can choose to spend
money on the bare necessities of the firm and manage it in a prudent
and profit maximizing way - or he can choose instead to spend the
money on perquisite consumption (perks) such as corporate jets, office
supplies for home use etc - stuff that costs the firm money, brings
benefit to the manager but not necessarily the shareholders.
Understanding how you handle Moral Hazard requires an understanding of
the way an explicit contract can alter the manager's behavior and the
limitations in enforceable contracts. Two important aspects of
managerial incentives are the upside and downside risks/potentials.
From the point of view of the manager, the upside potential is "how
much do I stand to gain through a particular action?" For example, the
answer in the case of buying a jet airplane is "I get to live the life
of luxury, spend less time on business travel and more time doing the
things I enjoy". If the manager is paid a fixed salary an extension to
that answer might be "I also get paid my usual wage, as long as the
company doesn't go bankrupt because of my excessive lifestyle".
The downside risk is "how much do I stand to lose through my actions?"
Again in the example of the jetsetting manager, the answer might be
"The company could go bankrupt, in which case I won't get paid my
salary" or if his contract forbids him from wasting money on airplanes
"I could get fired if I get caught - this would look bad on my
resume".
The problem with downside risk is that it is normally limited. What's
the worst that can happen? Being fired? A possible slow and drawn out
congressional judiciary hearing? Do I get to keep my house? Will I
really go to jail? Perhaps in an extreme culture you could fear for
your life, but it is normally assumed that the worst that can happen
is that you lose your job and hence get $0. On the other hand, it is
likely that a well performing company is unlikely to draw attention
from stockholders, so as long as the company does well, you can
continue to buy airplanes (perhaps a whole fleet of them), award
yourself bonuses, without any repercussions.
Most contracts can do little to control the downside and typically
enhance the upside potential.
My final comment is that this often leads to undesirable behavior just
by the inequality of the upside and downside potentials - especially
if the situation is dire. For example, suppose a manager is owed a
million dollar bonus but knows that the company only has $1000 in the
bank which is needed to pay bills before he gets his bonus. As it
stands, if he does nothing he gets no bonus, but the company can pay
its bills and stays in business (good news for shareholders).
Suppose the manager takes the $1000 to Las Vegas and gambles it all on
a 1000 to 1 bet. If he loses the bet, he gets nothing, the company
goes bankrupt, but he is no worse off than before. If however, he wins
he gets paid his bonus and the company remains in business.
Which would the manager choose? Probably the gamble - after all, he
gets paid more on average.
Which would the shareholders prefer? No gamble - that way they aren't
risking losing the company.
Hope that helps
calebu2
Definitions I found online :
From http://www.math.nyu.edu/fellows_fin_math/allen/institut_risk.pdf
which quotes the article “Moral Hazard” by Kotowitz in the
NewPalgrave, Allocation, Information, and Markets, p.207):
Moral hazard may be defined as actions of economic agents in
maximizing their own utility to the detriment of others, in situations
where they do not bear the full consequences or, equivalently, do not
enjoy the full benefits of their actions due to uncertainty and
incomplete or restricted contracts which prevent the assignment of
full damages (benefits) to the agent responsible. Agents may possess
informational advantages or there may be excessive costs in writing
detailed contingent contracts. Commonly analyzed examples are: workers
efforts,
which cannot be costlessly monitored by employers, and precautions
taken by the insured to reduce the probability of accidents and
damages due to them, which cannot be costlessly monitored by insurers.
Adam Smith in Wealth of Nations: “The directors of such companies,
however, being managers rather of other peoples’ money than of their
own, it cannot well be expected, that they should watch over it with
the same anxious vigilance with which the partners in a private
company frequently watch over their own.”
Prof Allen goes on to say :
Traders will always have greater participation in the upside of their
trades than in the downside. You can give a positive bonus but not a
negative one. Even firing does not have that large an effect — the
tendency is for firms to hire traders who have had spectacular blowups
elsewhere, figuring they’ve learned a lesson (at someone else’s
expense).
You may want to take a look through the notes by Ed Kane (The
professor who taught me the definition of Moral Hazard) :
http://www2.bc.edu/~kaneeb/ |
