Moral Hazard problems involve asymmetric information existing between two individuals which economists call the Principal and the Agent The Principal and Agent have a relationship from which they both benefit e g owner and employee or insurance agency and policy holder where the benefits to the Principal depends on how much effort the Agent exerts e g working hard to increase profits or going outside instead of smoking cigarettes in bed The Agent though doesn t like exerting the effort and would rather shirk not exert the amount of effort the Principal would like Moral Hazard problems arise when the Principal can only see the final result e g profit or whether or not the house burned down and can t figure out how much effort the Agent exerted So consider the owner of a car dealership Pamela The Principal and her employee Alan The Agent Both Pamela and Alan are risk neutral Alan can either choose to Work Hard and try to get people to buy cars or Shirk at his job and pretend he doesn t see the customers walking around the car lot In addition the profits of the business depend on whether or not a lot of people want to buy cars Demand for cars might be Low Medium or High with an equal chance of each Action of Alan Work Hard Shirk Low Demand 100 000 50 000 Medium Demand 150 000 100 000 High Demand 200 000 150 000 Profits for Pamela before subtracting the wages she has to pay to Alan are given by the above table So for example if Alan chooses to work hard demand for cars is medium and Pamela pays Alan 30 000 Pamela s profits are 150 000 30 000 120 000 Pamela only cares about her own profits Alan on the other hand cares about two things He cares about how much money Pamela pays him and how hard he has to work Alan s profit is given by the wage he is paid by Pamela minus 10 000 if he has to work hard So if Pamela pays Alan 35 000 and Alan works hard his profit is 35 000 10 000 25 000 If on the other hand Pamela still pays him 35 000 but he shirks his duties his profit is 35 000 0 35 000 In order to get Alan to work for her Alan s profit must be at least 30 000 on average incentive programs might change how much Alan gets paid in certain situations 1 If Pamela pays Alan 30 000 no matter what happens how much money will Pamela make on average 2 After looking at other firms compensation schemes Pamela decides to introduce a reward for Alan if he sells a lot of cars Specifically Alan will now be paid 120 000 if Pamela s profit before she pays Alan s salary is 200 000 ie If he works hard and demand is high If Pam s profit before paying Alan s salary is less that 200 000 he only gets 30 000 Is this a good idea for Pam 3 What would be the smallest bonus wage like the one in question 2 which would get Alan to Work Hard assuming if he didn t get the bonus wage his wage would be 30 000 4 Would your answer in question 3 change if Alan were risk averse instead of risk neutral Explain