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 the relationship between moral hazard and insurance premiumsarrow_forwardA buyer or seller must consider a number of risks when evaluating whether a long-term contract is necessary or even desirable. Three primary questions must be asked when developing a long-term contract and considering the risks: What is the potential for opportunism? In other words, how likely is the supplier to take advantage of the purchaser (or vice versa)? Is this the right supplier to engage in a long-term contract? C.Is there a fair distribution of risk and gains between the parties involved?arrow_forwardIs this how information is distributed in a normal organizational hierarchy?arrow_forward
- Hyundai has become the fastest–growing automotive brand in the United States by strategically using quality improvement. Which statement is true about Hyundai? * 2/2 Hyundai’s strategies are not related to its mission. Hyundai strategy is based on planning processes to achieve the company’s short-term goals. Hyundai’s mission and values do not influence its organizational culture. Hyundai’s organizational culture is a major determinant to the successful implementation of quality improvement.arrow_forwardWhich of the following is not a characteristic of principal-agent conflicts that often exist in a firm? Firms can usually find solutions that reduce agency costs without increasing monitoring or incentive costs. Managers do not always operate in the best interest of owners because managers care about the noncash benefits of their jobs. Managers generally have a shorter time horizon than owners; thus, managers do not fully take into account the future long-run profitability of the firm.arrow_forwardA. Briefly explain three risk exposures that an analyst should report as part of anenterprise risk management system. B. Define market risk and the economic parameters considered when calculatingmarket risk.arrow_forward
- The global recession forced thousands of firms into bankruptcy. Does this fact alone confirm that “external factors are more important than internal factors” in strategic planning?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_forwardDiscuss why in many liability firms, the managers do not receive a fixed payment for their work, but rather they are paid according to the results (such as profits or sales).arrow_forward
- What is the principal-agent problem? Have you ever worked in a setting where this problem has arisen? If so, do you think increased monitoring would have eliminated the problem? Why don’t firms simply hire more supervisors to eliminate shirking?arrow_forwardCrop Insurance. Consider a state in which farmers are divided equally into two types: high risk and low risk. The average annual crop loss (and possible insurance claim) is $400 for a low-risk farmer and $1,200 for a high-risk farmer. a. If all farmers were to buy insurance, what is the break-even price for the insurance company? $ (Enter your response rounded to the nearest whole number.) b. Suppose a farmer will purchase insurance only if the price (the annual premium) is no more than 50% higher than his or her average crop loss. What is the equilibrium price? $ (Enter your response rounded to the nearest whole number.)arrow_forwardIn this simple insurance model, a company has a monopoly over a small market. There are 100K potential customers with a low risk profile, 60K potential customers with a medium risk profile, and 10K potential customers with a high risk profile. A person’s risk profile is important as it determines how much insurance is worth to the customer and how much money the customer will cost on average to the insurance company. The following table summarizes the estimates put together by the company: Low risk profile Medium risk profile High risk profile Number of potential customers 100,000 60,000 10,000 Expected expense per customer $2K $7K $15K Maximal price the customer isready to pay for insurance $3K $8K $16K Remark: Explaining where these numbers come from would require a subtler model that describes the risk covered by the insurance policy. While there is no need to do this for the purpose of this exercise, notice though how the maximal price…arrow_forward
- Managerial Economics: A Problem Solving ApproachEconomicsISBN:9781337106665Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike ShorPublisher:Cengage Learning