Moral Hazard

Game Theory · Axiom Academy

Unit 5: Games with Incomplete Information In a moral hazard setting, a principal hires an agent to perform a task. The principal can observe the outcome but cannot observe the agent's effort level . This creates an incentive problem. The animation shows the information asymmetry: the principal observes only outcomes, not the agent's effort choice. 2. The Principal-Agent Framework The agent chooses effort level e at personal cost c(e) . Higher effort increases the probability of a good outcome. The principal observes the outcome and pays the agent according to a contract. The principal's challenge: design a contract that induces high effort without observing effort directly. 3. Incentive Design and Alignment To induce effort, the principal must make the agent's payment contingent on the observed outcome. Performance-based pay (bonuses, commissions, equity) aligns the agent's interests with the principal's by making effort personally profitable. The incentive compatibility constraint ensures the agent prefers high effort to low effort given the contract terms. 4. Risk Sharing vs. Incentive Tradeoff When the agent is risk-averse, there is a fundamental tradeoff: stronger incentives induce more effort but expose the agent to more risk (since outcomes are uncertain). The optimal contract balances these competing forces. Examples: CEO compensation packages, insurance deductibles, sharecropping contracts, franchise agreements.

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