Financial Intermediaries & Markets Lecture 3 PDF

Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process 3(b): Information Asymmetry...

Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process 3(b): Information Asymmetry 3(c): Case Study - Enron Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process 3(b): Information Asymmetry 3(c): Case Study - Enron Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(b): Information Asymmetry Reading Materials: 1. What is Securitization by IMF 2. Securitization by CFA 3. Insurance Coverage & Agency Models (Extract) 4. A Model of Moral Hazard Credit Cycle Asymmetric Information  What is Information Asymmetry? (1 bonus)  Asymmetric Information A situation in which one party to an economic transaction has better information than does the other party.  Asymmetric Information Leads to two major problems in financial markets: Adverse Selection Moral Hazard The problem investors The risk investors will face if experience in distinguishing borrowers take actions after low-risk borrowers from they have entered into a high-risk borrowers before transaction, and these actions making an investment will make the investors worse off  Asymmetric Information Recap: 1. What is information Asymmetry 2. What is Adverse Selection 3. What is Moral Hazard (1 bonus for all 3 correct)  Asymmetric Information Recap: 1. What is information Asymmetry One party has more info than another 2. What is Adverse Selection Risk that high-risk borrowers are selected rather than low-risk borrowers during the selection process 3. What is Moral Hazard Risk that borrowers change their behavior after selection causing damage to investors  Asymmetric Information Real-life Situation (sub-prime Mortgage Crisis): – During the mortgage market meltdown that started in 2007, record numbers of mortgage holders defaulted on their loans. Question 2: Question 1: Were these executives irresponsible? Why did executives at these banks take risks that resulted in Question 3: so much lost shareholder value? Did one party in each transaction have less knowledge than the other Question 5: party, i.e asymmetric information Were there any hidden action, i.e. Moral Hazard Question 4: Were there any hidden characteristic, i.e Adverse Selection?  Asymmetric Information Leads to two major problems in financial markets: Adverse Selection Moral Hazard The problem investors The risk investors will face if experience in distinguishing borrowers take actions after low-risk borrowers from they have entered into a high-risk borrowers before transaction, and these actions making an investment will make the investors worse off Asymmetric Information - Adverse Selection Due to lack of information (or fear of missing information), – some agents may decide not to engage in transactions to avoid being exploited by better informed counterparts What does this imply? – Not all desirable transactions occur i.e, potential consumer and producer surplus is lost. – In extreme cases, adverse selection may prevent a market from operating at all. Asymmetric Information - Adverse Selection Two important Adverse Selection Cases – insurance & – products of varying quality  a fair insurance rate = the Asymmetric Information - Adverse Selection average cost of health care for the entire population In the Insurance Market How would people react to a fair insurance rate? – Unhealthy people: These people incur health care costs that are higher than average – Therefore they would view the fair insurance rate as a good deal and many would buy it. – Healthy people: These people incur health care costs that are lower than average – Therefore they would not buy it because the premiums would exceed their expected health care costs (unless they are extremely risk averse). Asymmetric Information - Adverse Selection In the Insurance Market Consequences of Adverse Selection in Insurance Markets: – An Inefficient Market Outcome, since 1. Consumers Surplus isn’t maximized & Surplus I sn’t maximize 2. Producers Surplus isn’t maximized Fair Price & Full & Symmetric Information 13 Insurance 12 Premium 11 10 9 8 Consumer Surplus 7 Producer Surplus 6 5 4 3 2 1 1 2 3 4 5 6 7 8 9 10 11 Quantity of Health Insurance Asymmetric Information - Adverse Selection In the Insurance Market Consequences of Adverse Selection in Insurance Markets: – An Inefficient Market Outcome, since 1. Consumers Surplus isn’t maximized & Healthy people insured: Very few & Unhealthy people are insured: A disproportionately large share. Thus, consumers as a whole loose, – i.e Consumer Surplus isn’t maximize 2. Producers Surplus isn’t maximized The average cost of the medical care cover, thus, exceeds the population average. Thus the insurance companies as a whole loose, – i.e. Producers Surplus isn’t maximize  Fair Price & Symmetric Fair Price & Asymmetric Information Information 13 13 Insurance Insurance 12 12 Premium Premium 11 11 10 10 9 9 8 8 Consumer Surplus Consumer Surplus 7 7 Producer Surplus Producer Surplus 6 6 5 5 4 4 3 3 2 2 1 1 1 2 3 4 5 6 7 8 9 10 11 1 2 3 4 5 6 7 8 9 10 11 This Quantityoutcome could be changed with perfectQuantity of Health Insurance information of Health Insurance Then healthy people would buy insurance at a lower premium unhealthy people at a higher premium, but the insurer must first verify the health conditions of each prospective customer Asymmetric Information - Adverse Selection Two important Adverse Selection Cases – insurance & – products of varying quality  Asymmetric Information - Adverse Selection Products of Unknown Quality Sellers of a product have better information about the product’s quality than the buyer – E.g. The lemon problem in the transaction of a used car. Lets deviate to understand Lemon Akerlof, George (1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". Quarterly Journal of Economics. Problem Asymmetric Information - Adverse Selection Products of Unknown Quality Car Example –1,000 used cars buyers Buyers are willing to pay $ 4,000 for a lemon – The demand for lemons, , DL , is horizontal at $ 4,000 Price $ Price $ Buyers are willing to pay $ ,8000 for a good used car – The demand for good cars, , DG , is horizontal at $ 8,000 8000 8000 7000 7000 6000 6000 5000 5000 4000 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Car example – 1,000 used cars sellers Sellers cannot alter the quality The reservation price of lemon owners is $3,000, Price $ Price $ – so the supply curve for lemons, SL , is horizontal at $3,000 up to 1,000 cars, where it becomes vertical (no more cars are for sale at any price). 8000 8000 used cars is v, which is less than The reservation price of owners of high-quality $8,000. 7000 7000 Lets shows two possible values of v. 6000 – If v = $5,000, the supply curve for good cars, S1, is6000 horizontal at $5,000 up to 1,000 cars and then becomes vertical. 5000 – If v = $7,000, the supply curve is S2. 5000 4000 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Car example Now lets discuss Equilibrium when (i) Information is Symmetric & (ii) Information is Asymmetric Price $ Price $ 8000 8000 7000 7000 6000 6000 5000 5000 4000 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Price $ Price $ 8000 8000 E 7000 7000 6000 6000 5000 5000 4000 e 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Price $ Price $ 8000 8000 E 7000 7000 6000 6000 5000 5000 4000 e 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Car example: Equilibrium with Incomplete & Symmetric Information – Symmetric: all information is available – Incomplete: buyers and sellers are (equally) ignorant about available information on quality of cars Price $ Price $ – Equilibrium is then a weighted average EV = 0.5 x 8000 + 0.5 x 4000 = $6,000. 8000 A risk-neutral buyer and a seller would transact at $6,000. 8000 E – This market is efficient: the goods go to the people who value them the most. 7000 7000 6000 f 6000 F 5000 5000 4000 e 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Car example: Equilibrium with Asymmetric Information – Sellers know the quality of their cars but buyers do not – There are two possible equilibria. 1. If sellers value good cars at v = $5,000 and buyers consider EV = $6,000 All cars are sold at $6,000. Price $ Price $ The equilibrium points are f and F In this case asymmetric information does not cause an efficiency problem, but it does have equity implications. 8000 8000 E 2. If sellers value good cars at v = $7,000, and buyers consider EV = $6,000 7000 Sellers will not sell them at $6,000. 7000 6000 f Then, the lemons drive good cars out of the market, only 6000 lemons are sold at $4,000 F This leads to an inefficient equilibrium. - only lemons are sold 5000 5000 4000 e 4000 3000 3000 0 1000 0 1000 Quantity Per Year Quantity Per Year Market for Lemons Market for Good Cars Asymmetric Information - Adverse Selection Products of Unknown Quality Sellers of a product have better information about the product’s quality than the buyer – E.g. E.g. The In a lemon problem transaction of a in the car, used transaction ofknows the seller a used car. whether his car is a lemon, but the buyer cannot know it (hidden characteristic). Now we understand the Lemon Problem Asymmetric Information - Adverse Selection Products of Unknown Quality Consequences of Unknown Quality – If sellers have more information than buyers, adverse selection may drive high-quality products out of the market (Akerlof, 1970).  “Lemons Problems” in fin markets If 90% of stocks are good with $50 price and 10% are lemons with $5 price E(P) = 0.9*50 + 0.1*5 = 45.5 which is below the fundamental value of good stock. Question: What happen if Bonds’ rates increases? As bonds’ rates rises (i.e. creditworthiness of borrowers likely deteriorates) adverse selection worsens by increasing fraction of lemons among firms willing to pay high rates. Recall  “Lemons Problems” in fin markets Question: Why banks use credit rationing to limit loans instead of increasing the rate?? High rates may attract less creditworthy borrowers, unconcerned with paying high rates if close to bankruptcy. Also, in recession number of lemon borrowers increases. However, Credit rationing hurts all borrowers (good or lemons) making it harder for good ones. Asymmetric Information - Adverse Selection How to Reduce Adverse Selection Restricting Opportunistic Behavior – Restrict the ability of the informed party to take advantage of hidden information, by 1. Mandating Universal Coverage Health insurance markets have adverse selection because low-risk consumers do not buy insurance at prices that reflect the average risk. Such adverse selection can be eliminated by providing insurance to everyone or by mandating that everyone buy insurance. 2. Introducing Laws to Prevent Opportunism Product quality and product safety are known characteristics to sellers but not observed by buyers. Product liability laws protect consumers from being stuck with nonfunctional or dangerous products. Asymmetric Information - Adverse Selection How to Reduce Adverse Selection Equalizing Information – Ensure Information Provision to all parties. – 3 methods can be used: screening, signaling, and third party. 1. Screening Insurance companies screen potential customers based on their health records or medical exams. – They collect information until marginal benefit and marginal cost from the extra information are equal. Buyers of used cars test or drive the cars, bring a trusted mechanic, or buy only from sellers with good reputation. – Reputation is not easy to get in markets where buyers or sellers trade only once, like in tourist areas. Asymmetric Information - Adverse Selection How to Reduce Adverse Selection Equalizing Information – Ensure Information Provision to all parties. – 3 methods can be used: screening, signaling, and third party. 2. Signaling An informed party may signal the uninformed party to eliminate adverse selection. – Examples: – A firm distributes financial accounts audited by an independent accounting agency – A candidate for life insurance may present a health report signed by a doctor Asymmetric Information - Adverse Selection How to Reduce Adverse Selection Equalizing Information – Ensure Information Provision to all parties. – 3 methods can be used: screening, signaling, and third party involvement. 3. Third Party involvement Quality information provided by agencies like consumer groups, nonprofit organizations, and government. These can be done through standards and certification.  Asymmetric Information - Adverse Selection How to Reduce Adverse Selection Question: Has Securitization Increased Adverse Selection Problems in the Financial System? – Securitization: involves bundling loans, such as mortgages into securities, and these securities are then traded in financial markets. – Yes securitization led to an increase in adverse selection – Securitization changed banks’ focus of relationship banking to the originate-to-distribute business model banks sell loans to others rather than holding them to maturity. – As such the Securitization and the originate-to-distribute model reduced banks’ incentive to distinguish between good borrowers and lemon borrowers.  Asymmetric Information Leads to two major problems in financial markets: Adverse Selection Moral Hazard The problem investors The risk investors will face if experience in distinguishing borrowers take actions after low-risk borrowers from they have entered into a high-risk borrowers before transaction, and these actions making an investment will make the investors worse off  Asymmetric Information – Moral Hazard Focus in on i. the insurance market & ii. the principal-agent relationship.  Asymmetric Information – Moral Hazard Focus in on i. the insurance market & ii. the principal-agent relationship. – Moral Hazard in Insurance Markets Many types of insurance are highly vulnerable to hidden actions by insured parties that result in moral hazard problems. Example 1: – A business insures merchandise in a warehouse against hazards such as fire and theft. – If merchandise is not selling, the owner faces a significant financial loss. – He may burn down the warehouse and make an insurance claim. Example 2: – If doctor’s visits are free and unlimited with health insurance, the insured may make ‘excessive’ visits.  Asymmetric Information – Moral Hazard Focus in on i. the insurance market & ii. the principal-agent relationship. – Moral Hazard in Principal – Agent Relationship When responsibilities are delegated, a principal contracts with an agent to take an action that benefits the principal. If the agent’s actions are hidden, moral hazard may result. Example: – A business owner (principal) hires an employee (agent) to work at a remote site – The Principal cannot observe whether the Agent is working hard. – The employee may avoid duties for which he is paid to provide  Asymmetric Information – Moral Hazard Example of a Principal-Agent Problem: – The Moral Hazard and Selfish Doctors Study Case in China Patients (principals) rely on doctors (agents) for good medical advice with respect to drug prescriptions. Question: Do doctors act only in their patient’s best interests? Lu (2014) “Insurance Coverage and Agency Problem in China” – Doctors prescribed similarly whether or not a patient had insurance. – This holds true only if the doctors received no compensation for prescriptions. – However, if doctors were compensated, they prescribed drugs that cost 43% more on average for insured patients than for uninsured patients. – Thus, many of these doctors appeared to be motivated largely by self-interest.  Asymmetric Information – Moral Hazard How to Reduce Moral Hazard Using Efficient Contracts, and Using Monitoring  Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Reducing Moral Hazard using Efficient Contracts – The principal and agent can agree to an efficient contract: – An agreement in which neither party can be made better off without harming the other party. If the parties to the contract are risk neutral: – efficiency requires that the combined profit of the principal and agent be maximized. If one party is more risk averse than the other: – efficiency requires that the less risk-averse party bear more of the risk. – In the previous example: Efficiency occurs if the agent works extra hard so total profit is maximized Or if the agent (risk averse party) bears none of the risk. Financial Intermediaries & Markets Lecture 3: Nature of Financial Intermediaries 3(b): Information Asymmetry End of 3(b) Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Moral Hazard & Efficient Contracts: Ice Cream Shop – Paul (principal) owns many ice cream parlors across North America. He contracts with Amy (agent) to manage his Miami shop. Her duties include supervising workers, purchasing supplies, and performing other necessary actions. – The shop’s daily earnings depend on the local demand conditions and on how hard Amy works (Table 1). Demand can be high or low depending on weather conditions (50%) and Amy can put in normal or extra effort (valued $40 per day). – Paul is risk neutral because he can pull earnings from the many stores he owns. Amy, like most people, is risk averse. – We know an efficient contract requires Amy to bear no risk, but the outcome depends on symmetric and asymmetric information. Ice Cream Shop Efficient Contract & Symmetric Information – Moral hazard is not a problem if Paul can directly supervise Amy and agree that: Amy earns $200 per day if she works extra hard, but loses her job if she doesn’t. – Amy’s zero risk: She gets $200 independently of weather. – Amy’s incentive to work hard: She nets $160 (200-40), better than being fired. – Paul bears all risk: EV = $200; σ2 = 10,000 (perfect monitoring row in Table 2) – Efficient contract: Profit maximized, risk averse agent bears no risk. Asymmetric Information – Moral Hazard Using Table Contracts 1: Ice to Profits Cream Shop Reduce Moral Hazard Asymmetric Information – Moral Hazard Using Contracts to Reduce Table 2 Ice Cream Shop Outcomes Moral Hazard Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Ice Cream Shop Inefficient Contract & Asymmetric Information – Moral hazard is a problem if Paul cannot observe Amy’s effort. Both agree on a fixed-fee contract: Amy earns $100 per day. – Amy’s zero risk: She gets $100 independently of weather. – Amy’s incentive to work normally: If she works normally, she gets $100. But, if she works hard, she only nets $60 (100-40). – Paul bears all risk: EV = $100; σ2 = 10,000 (fixed wage row in Table 2) – Inefficient contract: Profit is not maximized, although risk averse agent bears no risk. Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Contracts and Correct Incentives – A skillfully designed contract that provides strong incentives for the agent to act so that the outcome is always efficient may solve moral hazard problems. – We will focus on fixed-fee and contingent contracts. Fixed-Fee Contracts – Amy could pay Paul a fixed license fee to operate Paul’s shop. Paul bears no risk as he receives a fixed fee, Amy bears all the risk and gets the residual profit. – Paul makes $200 with certainty. – Amy’s incentive to work hard: She earns all the increase in expected profit from her extra effort. EVHARD = $160 > -$100 = EVNORMAL, σ2 = 10,000 – Efficient contract: Licensing fee profit > fixed wage profit in Table 2 (360 > 200). However, it does not provide efficient risk bearing. – If Amy is nearly risk-neutral, she picks the license fee. If she’s highly risk-averse, she picks the fixed wage.  Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Contingent Contracts – Many contracts specify that the parties receive payoffs that are contingent on some other variable. – If monitoring is possible, contingency may be the action taken by the agent. – If monitoring is not possible, payoff may be contingent to the state of nature, profit sharing, bonuses & options, piece rates and commissions. State Contingent Contracts – In a state-contingent contract, one party’s payoff is contingent on only the state of nature (weather conditions determine low and high demand). – Contract: Amy pays a license fee of $100 if demand is low and $300 if demand is high, and keeps all extra earnings (state-contingent row in Table 15.2) – Amy’s incentive to work hard: Working normal she nets zero. She must work hard. – Amy bears no risk: EVHARD = $160 = EVNORMAL, σ2 =0. – Paul bears all risk: EV = $200, σ2 =10,000. – Efficient outcome: Profit is maximized, risk averse agent bears no risk. Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Profit Sharing – A profit-sharing contract: the payoff to each party is a fraction of the observable total profit (profit sharing row in Table 15.2). – Contract: Paul and Amy agree to split the earnings of the ice cream shop equally. – Amy’s incentive to work hard and risk: EVHARD = $160 > $100 = EVNORMAL, and σ2 = 2,500 for both efforts. She prefers to work hard. – Paul earnings: EV = $200, and he is risk neutral. – Efficient outcome: Profit is maximized but risk averse agent bears risk. Paul prefers this contract to a fixed-fee contract. Amy works hard if her profit share > 20%. Bonuses – A principal offers the agent a bonus: extra payment if a performance target is hit. – Contract: Paul offers Amy a base wage of $100 and a bonus of $200 if the shop’s earnings (before paying Amy) exceed $300 (wage and bonus rows in Table 15.2) – Amy’s incentive to work hard: Working normal she nets $100. Working hard, EVHARD = $160 and σ2 =10,000. Her choice depends on her risk-averse level. – If Amy is nearly risk neutral, she works hard (before last row in Table 15.2). – If Amy is highly risk-averse, she works normal (last row in Table 15.2). – Efficient outcome: Profit is maximized only if Amy is risk neutral. Asymmetric Information – Moral Hazard Using Contracts to Reduce Moral Hazard Options – An option gives the holder the right to buy up to a certain number of shares of the company at a given price (the exercise price) during a specified time interval. – An option provides a benefit to the executive (agent) if the firm’s stock price exceeds the exercise price and is therefore a bonus based on the stock price. Piece Rates and Commissions – Piece rate contract: agent receives a payment per unit of output produced. – Contract: Amy is paid for every serving of ice cream she sells. It gives her an incentive to work hard, but she bears the risk from fluctuations in demand. – Revenue-sharing contract or commissions: agent receives some share of revenues earned – Contract: Amy gets a 5% commission for every serving she sells. It gives her an incentive to work hard, but she bears the risk from fluctuations in demand. – Efficiency: Commissions provide an incentive for agents to work harder than they would with a fixed-rate contract. But, this incentive is not necessarily strong enough to offset the agent’s cost of extra effort and the agent bears some risk. Asymmetric Information – Moral Hazard Using Monitoring to Reduce Moral Hazard Problem and Monitoring Solution – Moral Hazard Problem: employees who are paid a fixed salary have little incentive to work hard if the employer cannot observe shirking. And if paid by the hour but employer but cannot observe how many hours they work, employees may inflate the number of hours they report working. – It pays to prevent shirking by carefully monitoring and firing employees who do not work hard if the cost of monitoring workers is low enough. Low Cost Monitoring Practices – Most common types of surveillance: tallying phone numbers called and recording the duration of the calls (37%), videotaping employees’ work (16%), storing and reviewing e-mail (15%), storing and reviewing computer files (14%), and taping and reviewing phone conversations (10%). – Nearly 75% of employers monitor and surveillance employees (81% in the financial sector). Firms usually monitor selected workers using spot checks. – A quarter of firms that monitor employees do not tell them. Asymmetric Information – Moral Hazard Using Monitoring to Reduce Moral Hazard Monitoring May be Counterproductive – For some jobs, however, monitoring is counterproductive or not cost effective. Monitoring may lower employees’ morale, which in turn reduces productivity. – Example: Northwest Airlines took the doors off bathroom stalls to prevent workers from staying too long in the stalls. When new management eliminated this policy, productivity increased. Monitoring Difficulties – As telecommuting increases in the work place, monitoring workers may become increasingly difficult. – A firm’s board of directors is supposed to represent shareholders (principals) by monitoring senior executives (agents). Are they good in monitoring? – No. In a study of firms in which senior executives engaged in illegal price-fixing, exposing the firm to significant legal liability, it was found that these executives were more inclined to recruit directors who were likely to be inattentive monitors.  Asymmetric Information – Moral Hazard Using Monitoring to Reduce Moral Hazard Hostages – When direct monitoring is very costly, firms often use contracts containing various financial incentives to reduce the amount of monitoring that is necessary. These incentives act as a hostage for good behavior. – Hostage incentives are bonding, deferred payments, and efficiency wages. Bonding to Reduce Monitoring Efforts – One way to ensure agents behave well is to require them to deposit funds guaranteeing their good behavior. – Example: an employer (principal) may require an employee (agent) to provide a performance bond, an amount of money that will be given to the principal if the agent fails to complete certain duties or achieve certain goals. – Posting bonds is common in couriers who transport valuable shipments or guards who watch over them, and construction contractors. – 1st problem: If the employee fears the employer will opportunistically retain the bond, it will not deposit it. Solution, firm reputation & independent verification. – 2nd problem: The employee may not have enough wealth. Asymmetric Information – Moral Hazard Using Monitoring to Reduce Moral Hazard Deferred Payments to Reduce Monitoring Efforts – Firms can post bonds for their employees through the use of deferred payments. – Example: A firm pays new workers a low wage for some initial period. Then, workers who are caught shirking are fired, good workers remain at higher wages. – Example: The firm provides a retirement pension that rewards only workers who stay with the firm for a sufficiently long period of time. – Problem: Employers may fire good workers to avoid paying higher wages or retirement pensions. Solution: firm reputation & independent verification. Efficiency Wages to Reduce Monitoring Efforts – Managers can often reduce employee shirking by paying an efficiency wage: an unusually high wage above the worker’s opportunity cost. – Incentive to reduce shirking: if the worker is fired and finds another job, the amount offered elsewhere is less than the efficiency wage. Worker works hard. – Firm increases profit if the saving from reducing shirking exceeds the cost of the higher wage (marginal benefit > marginal cost). Asymmetric Information – Moral Hazard Using Monitoring to Reduce Moral Hazard After-the-Fact Monitoring – So far we’ve concentrated on monitoring by employers looking for undesirable behavior as it occurs. – However, it is often easier to detect the effects of shirking or other undesirable actions after they occur. Punishment Discourages Shirking – Example: An employer can check the amount that an employee produces or quality of work after it is completed. If shirking is detected after the fact, the offending employee may be fired or disciplined. This punishment discourages shirking in the future. – If an insurance company determines after the fact that an insurance claim resulted from behavior rather than chance, the firm may refuse to pay. This punishment reduces opportunistic behavior.  Managerial Solution Managerial Problem – Why did executives at these banks take risks that resulted in so much lost shareholder value? How can a firm compensate its corporate executives so as to prevent them from undertaking irresponsible and potentially devastating actions? Solution – It seems managers of these banks took excessive risks because their risky actions were hidden, they were compensated for success, and not substantially penalized for failure. – One solution is to provide incentives that penalize them relatively more for failure, a combination of fixed salary with bonus and the penalty of firing the executive if the firm has a loss. – Another is to increase independent monitoring of executive payment contracts. Moral hazard was common partly because these contracts were designed by senior executives themselves. If shareholders had symmetric information, they would have objected, but few shareholders had the time, ability, or sufficient information to scrutinize executive compensation contracts.