Question

You are about to start working at car dealership that is currently reporting losses due to flooding but will be profitable in a few years. Assume you’re your risk adverse and your supervisor cannot fully monitor your actions. The key metrics at this dealership include both financial data (number of sales, margin on sales) as well as qualitative data (survey of experience). You are tasked with designing a compensation contract.

1. Define in your own terms moral hazard and adverse-selection. Describe how the firm may want to establish a compensation contract for you given moral hazard and adverse selection issues.

2. Does this change depending on your level of risk aversion?

3. Discuss both tax and nontax factors from both the employee and employers perspective.  

4. Suppose a firm has a tax loss in the current period of $200, which when added to prior tax losses gives it an NOL carryforward of $300. The top statutory tax rate is 21%. Assume an after-tax discount rate of 10% and future taxable income of $50 per year. What is the firm’s marginal explicit tax rate?

5. Create the compensation contract with points 1-4 in mind. Keep this contract to a single page. You will be graded on creativity, presentation, and writing clarity.

Answer 1

Here your solution

1)

: Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

Description: In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan.

It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.

Example: You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishappening like fire or burglary. Hence you will show extra care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any unforeseen event.

But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

How Adverse Selection Works

Adverse selection describes an undesired result due to the situation where one party of a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. The asymmetry causes a lack of efficiency in the price and quantity of goods and services. Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.

For example, assume there are two sets of people in the population, those who smoke and do not exercise, and those who do not smoke and do exercise. It is common knowledge that those who smoke and don't exercise have shorter life expectancies than those who don't smoke and do exercise. Suppose there are two individuals who are looking to buy life insurance, one who smokes and does not exercise and one who doesn't smoke and exercises daily. However, the insurance company cannot differentiate between the individual who smokes and doesn't exercise and the other person.

The insurance company asks the individuals to fill out questionnaires to distinguish them. However, the individual that smokes and doesn't exercise knows that answering truthfully means higher insurance premiums, so he lies and says he doesn't smoke and exercises daily. This leads to adverse selection, where the life insurance company is at a disadvantage and then charges the same premium to both individuals. However, the insurance is more valuable to the non-exercising smoker than the exercising non-smoker because one party has more to gain.

2)

Agri‐environmental policy is modelled as a social welfare maximisation problem that recognises the potential trade‐off between increased environmental benefit and increased cost of monitoring compliance. Moral hazard arises because monitoring does not detect all those who fail to comply with contractual obligations. It is shown that if monitoring costs are negligible of fixed, or farmers are highly risk averse, the moral hazard problem can be eliminated. However, if monitoring costs depend on monitoring effort and the degree of risk aversion is low, only a second‐best solution can be obtained. Numerical simulations suggest that optimal monitoring effort declines with increasing farmer risk aversion.

3) & 4).

A contract is an understanding under which two parties make corresponding duties as far as their conduct, being a "two-sided coordination arrangement". This formulation addresses the lawful idea of the contract yet additionally rises above it. Throughout the last thirty years, the "contract" has turned into a focal idea in monetary analysis, offering ascend to three central fields of study: "motivating forces", "fragmented contracts" and "transaction costs".

This article will concentrate on the subject of adverse selection and moral hazard in contract law. While adverse selection is an antagonistic choice, and an issue of concealed data, it reveals ex-stake, moral hazard, an issue including shrouded activity, uncovers an ex-post phenomenon. Both suggest negative impacts on contract proficiency and costs and touch either field of study: motivating forces, fragmented contracts and transaction costs.

Negative impacts, for example, the impact on transaction costs and in addition the impact of deficient contracts will be discussed in this article. Legally binding and financial solutions, for example, flagging, deductibles and indemnity and valued contracts with a specific end goal to limit or maintain a strategic distance from both adverse selection and moral hazard is been viewed from there on.

For definition, A contract is any promise or set of promises made by one party to another. If there should arise an occurrence of a rupture of contract, the law gives a cure. The promise or guarantees might be communicated either written or oral or might be suggested from circumstantial conditions. Where an agreement is a solitary association between parties, contract law is the segment of common law that translates written understandings amongst parties and resolves debate between them as a rule.

Contract law itself has a few purposes to accomplish proficiency likewise, for example, to empower individuals to participate by changing over diversions with a non-helpful arrangement into an agreeable arrangement and accordingly to accomplish proficient outcomes. Ideal sense of duty regarding execution and the securing of ideal dependence are different reasons for contract law that should guarantee a productive result. Contract law additionally supplies default terms that should be effective to limit transaction costs of negotiating contracts and the law might adjust advertise disappointments by directing the terms of an agreement.

On the off chance that an agreement would be complete and efficient, without holes and disappointments, then contract law would not be essential, in any event not in the feeling of settling contentions in court. Be that as it may, a total contract actualizes that each conceivable possibility is expected, related dangers or risks are efficiently dispensed, and all pertinent data has been conveyed. In any case, this would infer enormous transaction costs and hence crash into the reason for contract law, which is to limit those expenses for the objective of effectiveness.

Asymmetric information or topsy-turvy data or data asymmetry depicts the circumstances where one party in a contract has data which is better than that of the other party - or in like manner words: one party knows more than the other party does. It essentially depicts the disappointment of the parties to impart to each other all the important data, required for the two parties inside the agreement or contract. Be that as it may, data asymmetries likewise happen when data is deliberately covered up or hidden (shrouded data). Those asymmetries thus prompt inefficient behavior, being the reason for "adverse selection or choice".

Adverse selection in its place is a term from the new establishment of economics or financial matters and assigns a condition, in which undesirable outcomes are acquired. Moral hazard is the name given to the hazard that one party to an agreement can change their conduct to the hindrance of the other party once an agreement has been finished up ex-post.

Moral hazard is an issue of concealed activity, upheld by data asymmetries practically equivalent to unfavorable determination. For instance, for a blemished arrangement the expenses for the principal may lie underneath the expenses for the agent to satisfy the contract. Be that as it may, the risk of moral hazard only occurs whenever it is difficult for the principal to monitor the agent.

The negative impacts discussed don't just emerge because of the presence of adverse selection or moral hazard by and large but also due to the fact that the former and the latter create spillovers if they want to be avoided.

Adverse selection, determining or being caused by asymmetric information can be kept at a strategic distance by the assistance of gathering additional data, if the other party of the agreement isn't willing to contribute this data itself. Notwithstanding, sourcing data meets up with extra costs that are known as transaction costs in contract law.

As a rule, it is said that obliviousness (not getting more data) is judicious when the expenses of obtaining extra data surpass the normal advantage from gaining it, consequently the buyer, alluding to the primary principal- agent concept, would need to and will source more data as long as the expenses of recovering it are underneath the expenses of dispensing the misfortune or loss.

Regardless, these costs, alluded to as transaction costs in contract law are to the detriment of efficiency and might hinder the enforcement of contracts. Contracts or their satisfaction have risks. While a few risks are designated unequivocally others may stay quiet, implying that they are not expressly specified. On the off chance that an agreement stays silent about a hazard, the agreement is said to have a "hole". Holes may be in an agreement, in light of the fact that the likelihood of a specific hazard isn't predicted, those holes are called "incidental holes". In the event that the likelihood of a hazard is somewhat remote, then the hole not covering this hazard is called "deliberate hole". In either case the agreement is said to be "fragmented or incomplete".

On the off chance that parties agree to express terms to allocate risks, they bear a specific transaction cost contrasted with exchange costs with a positive likelihood on the off chance that they leave a hole. The instance of moral hazard challenges contracts from various perspectives. Right off the bat, moral hazard is an ex-post issue, and happens after an agreement was at that point made. Furthermore, moral risk gets from shrouded activity and is in this way not predictable for the other party of the agreement. Thirdly, shrouded activity on account of moral hazard is for the most part purposefully with the goal that the party committing hidden action will surely not uncover the information to the other party on any event.

The issue is that 'hole filling' would infer to source more data. In this way, alluding to the principal-agent aspect, where the principal can't screen the agent, the principal would need to source more data on the agent. This may be by and large unrealistic, since the agent neutralizes in unveiling his goals. Also, sourcing more data is a weight factor on the transaction costs. Nonetheless, the principal will gather more data as long as the cost of extra data is beneath the cost of apportioning the normal misfortune or expected loss.

But how can these effects be limited without reducing the range of coverage?

Incentives to avoid adverse selection and moral hazard: There are economic as well as pure legal incentives in order to avoid or at least to reduce adverse selection and moral hazard. Flagging or Signaling, deductibles as well as indemnity and valued contracts are the four of the possibilities to handle the problem.

To conclude, this article demonstrates that both adverse selection and moral hazard are a phenomenon, where adverse selection thwarts parties from even efficient contracting, caused by judicious choice under asymmetric information, moral hazard is the objective however corrupt aim of a party to an agreement to ex-post to re-modify its position to possess advantage but to the detriment of the other party.

In contract law both adverse selection and moral hazard thwart contracting and pose difficulties to contract law with a specific end goal to limit or keep away from the negative stretches. There are a few methodologies in either economic or monetary or legal field of study to quit moral hazard and to maintain a strategic distance from adverse selection. All suggest impacts on the transaction costs however intend to accomplish a pareto-effective outcome and to achieve efficiency in general, even if it is not always the case, as the example of signaling shows.

On the whole one might say that a re-distribution of risks or misfortunes towards the agent (the promisor) dependably imposes a positive effect on the reduction to the incentive of moral hazard but also on adverse selection.