Moral Hazard Class Problem and Solution

The “Moral Hazard Lecture–March 9, 2021” video features a class problem that carefully examines how to go about designing a so-called “incentive-compatible” contract between a corporate owner (the principal) and manager (the agent). The key insight is that moral hazard can be mitigated by ensuring that both the principal and the agent have “skin in the game”.  In this class problem, this is accomplished by offering the corporate manager an incentive compensation scheme involving a cut in salary that is supplemented by a bonus if certain profit targets are met.

The class problem is available at http://risk.garven.com/wp-content/uploads/2020/10/Moral-Hazard-Class-Problem.pdf, and its solution is available at http://fin4335.garven.com/spring2021/moralhazardsolutions.pdf.

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