Moral Hazard: Moral Hazard and the Theory of the Firm

The trade-off between risk and incentives provides one possible explanation of the wage compensations used in firms.19 The widespread use of stock options for CEOs can be seen as a result of the desire of the firm’s owners to let these agents bear more risk so that they are better incentivized.20 Similarly, the use of low- powered incentives for workers within the firm can, according to the paradigm, be viewed as evidence that the firm’s owners have only imperfect measures of the workers’ performances or that the workers are much more risk-averse than the top management of the firm.

The moral hazard paradigm is not only useful for understanding the internal structure of the firm, but it also provides insights on the relationship of the firm with many of its possible stakeholders: equity-owners, debtholders, regulators, and consumers. The corporate finance literature has advanced the view that the capital structure of the firm is not irrelevant21 once agency conflicts are explicitly taken into account.22 For instance, Jensen and Meckling (1976) argued that a conflict exists between equity-owners and managers because the managers only get a frac- tion of the firm’s profit but bear the full cost of their own effort in enhancing the firm’s profitability. Later on, Jensen (1986) stressed that debt contracts have significant value in this context because they force managers to pay out cash. By paying cash, the amount of free-cash flows available to engage in perks and other profit-reducing activities diminishes, and this strategy relaxes the agency problem. Simultaneously, the debt contract also introduces a conflict of interests between debtholders and equity-owners who fail to invest optimally at the ex ante stage because they only get a fraction of the firm’s return. More generally, the corporate finance literature has shown how the capital structure of the firm may be used as a powerful incentive device.

Moral hazard within the firm may be also affected by the economic envi- ronment in which the firm evolves. The general idea here is that markets may complement the formal incentives that contracts offer. Fama (1980) was an earlier contribution arguing that the labor market may provide enough implicit incentives for the managers to exert effort. Managers are willing to build a reputation as being efficient, and to do so they should exert the first-best level of effort even in the absence of formal contracts. Holmström (1999a) formalized this idea in a model where the manager’s talent is unknown and his past performances are affected by effort, talent, and random noise.23 He showed that reputation generally fails to provide enough incentives to the agent.

Since Leibenstein (1966), it has often been suggested that market discipline might also tend to remove inefficiencies within the firm. Hart (1983b) argued that the price mechanism may reduce the manager’s incentives to shirk. However, the feedback between competition and the power of incentive contracts within the firm is complex and highly dependent on the specifications made both on preferences and on the nature of competition as it was later on argued by Scharfstein (1988a) and Schmidt (1997).

Finally, it has also been argued that financial markets might play a role in disciplining management. In a case where the firm performs too badly, outsiders may take over the firm and replace its management to implement profit-enhancing actions. The threat of a takeover may thus appear as a substitute to an ineffi- cient provision of incentives. However, this simple argument fails to explain why those profit-enhancing actions cannot be implemented by the initial owners of the firm by changing the managers’ incentive schemes themselves. Two possible expla- nations are that the raider may have acquired private information on the firm’s technology24 or that synergies become possible once the raider has acquired the firm.

Source: Laffont Jean-Jacques, Martimort David (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.

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