Question

What examples of moral hazard or the principal-agent problem have you experienced? For example, have you been told you need more car repairs than necessary?

Do you observe fellow employees spending time doing personal business rather than working during business hours?

What are some solutions to the principle-agent problem?

Answer 1

Principal-agent problems occur when the principal of an entity hires on a company or individual employee to complete designated tasks that have a tendency to solely benefit the principal and compete with the best interests of the company or employee who is asked to complete the tasks.

When this type of situation arises, moral hazards occur. A moral hazard typically involves information that has been issued by a company when entering into contract with another company or an agent being deliberately skewed or altered in order to attempt to make a profit on a contract. The agent involved will find himself in a situation where he is forced to abide by unfavorable contract terms for fear of losing out on the business deal. The agent may have also been offered incentives too tempting to refuse, leading him to make a decision that is costly to him while benefiting the principal.

A moral hazard can arise anytime an agreement is entered into between two entities. Although an agreement has been reached, either party may decide to act in a way that skews the agreement. A clear example of a moral hazard occurs in the case of a salesperson who is compensated at an hourly rate with no commission. The salesperson in this situation may be inclined to put less effort into his performance, as the rate of pay doesn't change regardless of how hard he works. Typically this sort of situation can be avoided by altering the pay structure to include both an hourly salary and commission to serve as a performance incentive. This proves favorable to both company and employee in this scenario.