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The trade-off between incentives and endogenous risk

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  • Aloisio Araujo
  • Humberto Moreira

Abstract

Standard models of moral hazard predict a negative relationship between risk and incentives, but the empirical work has not confirmed this prediction. In this paper, we propose a model with adverse selection followed by moral hazard, where effort and the degree of risk aversion are private information of an agent who can control the mean and the variance of profits. For a given contract, more risk-averse agents supply more effort in risk reduction. If the marginal utility of incentives decreases with risk aversion, more risk-averse agents prefer lower-incentive contracts; thus, in the optimal contract, incentives are positively correlated with endogenous risk. In contrast, if risk aversion is high enough, the possibility of reduction in risk makes the marginal utility of incentives increasing in risk aversion and, in this case, risk and incentives are negatively related

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 Latin American Meetings with number 152.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:latm04:152

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Keywords: Incentives; non-monotone contracts; single-crossing property.;

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  1. Holmstrom, Bengt & Milgrom, Paul, 1991. "Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design," Journal of Law, Economics and Organization, Oxford University Press, vol. 7(0), pages 24-52, Special I.
  2. Araújo, Aloísio Pessoa de & Moreira, Humberto Ataíde, 2001. "Adverse Selection Problems without The Spence-Mirrlees Condition," Economics Working Papers (Ensaios Economicos da EPGE) 425, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  3. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
  4. Pierre-Andre Chiappori & Bernard Salanie, 2000. "Testing for Asymmetric Information in Insurance Markets," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 56-78, February.
  5. Guesnerie, Roger & Laffont, Jean-Jacques, 1984. "A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm," Journal of Public Economics, Elsevier, vol. 25(3), pages 329-369, December.
  6. Ghatak, Maitreesh & Pandey, Priyanka, 2000. "Contract choice in agriculture with joint moral hazard in effort and risk," Journal of Development Economics, Elsevier, vol. 63(2), pages 303-326, December.
  7. Canice Prendergast, 2002. "The Tenuous Trade-off between Risk and Incentives," Journal of Political Economy, University of Chicago Press, vol. 110(5), pages 1071-1102, October.
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Cited by:
  1. Paulo Klinger Monteiro, 2004. "The set of equilibria of first-price auctions," Microeconomics 0403001, EconWPA.
  2. Monteiro, Paulo Klinger, 2004. "First-Price auction symmetric equlibria with a general distribution," Economics Working Papers (Ensaios Economicos da EPGE) 568, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  3. Cavalcanti Ferreira, Pedro & Facchini, Giovanni, 2005. "Trade liberalization and industrial concentration: Evidence from Brazil," The Quarterly Review of Economics and Finance, Elsevier, vol. 45(2-3), pages 432-446, May.

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